Section 1031 of the Internal Revenue Code (IRC) is one of the more useful tools available to U.S. taxpayers. Section 1031 allows taxpayers to defer recognition of capital gains when they “exchange” their property for other property of a like-kind. Hence, a transaction under that section of the tax code is commonly referred to as a “1031 exchange” or like-kind exchange by professionals in the 1031 exchange industry. Ordinarily, an investor who cashed out of his or her investment through a sale would incur an immediate tax liability, but with a 1031 exchange, this liability can deferred, thereby allowing additional monies to be invested in a more expensive, potentially better-performing, investment property.
Section 1031 has a long history: the provision was created nearly 100 years ago, and today it is frequently invoked by investors seeking to maximize the return on their invested capital. The rationale for Section 1031 consists of two parts: (1) the section is designed to promote economic activity in general, and (2) the section is meant to avoid unfair taxation by not recognizing gains which occur merely “on paper.” In its earliest stages, Section 1031 was typically used to clarify property lines between neighboring farmers; gradually, however, over time, more and more investors began using this section specifically as a wealth creation device. Thousands of 1031 exchanges are conducted every year in the U.S. as investors seek to defer gains and acquire more productive investment properties.
The fate of the 1031 exchange recently came up as Congress made its latest tax code revisions. Some people contended that the 1031 exchange has lost its connection to its original purpose and has become merely a “loophole” in need of either modification or elimination; on the other end of the spectrum, others argued that Section 1031 contributes to the national economy by promoting transactional activity and increasing wealth among investors. Congress considered multiple avenues, but ultimately the 1031 exchange was preserved, even as personal property exchanges were eliminated. In this article, we will summarize the arguments on both sides of this exciting debate and then briefly discuss some of the trends in the current 1031 exchange industry.
Naysayers: Close the Loophole
Arguments against the 1031 exchange tend to emphasize the continually worsening financial condition of the federal government, or they highlight the evolution of 1031 away from its alleged true purpose. Under Section 1031, taxpayers are allowed to defer capital gain taxes for as long as they hold their property, and this can result in the deferral of very large tax liabilities. If a corporation, for example, sells real estate with a value of $100 million and has substantial gains, it’s clear that the federal government is missing out on a large chunk of income when the corporation performs a 1031 exchange in conjunction with such a sale. Given the financial condition of the government, there may be an argument that the closing of 1031’s provisions is necessary to help the government’s pocketbook.
Those who favor shutting down or curtailing Section 1031 sometimes also point to the fact that exchange transactions look very dissimilar than they looked at the time when the 1031 exchange was initially developed. When like-kind exchanges were first introduced in 1921 – at that time, Section 1031 was known as Section 112 – they were performed less frequently and, oftentimes, they were not carried out solely for the purpose of wealth maximization. Opponents of 1031 reasonably argued that the current 1031 exchange industry is out of step with the original “purpose” of the code and therefore reform is needed.
Yay-sayers: Preserve the Like-Kind 1031 Exchange
Supporters of Section 1031 emphasize the twin principles on which the code was founded. Supporters highlight the fact that 1031 exchanges promote related economic activity by driving construction services, title insurance services, broker services and similar activity. Eliminating the 1031 exchange would have the unfortunate consequence of simultaneously reducing these related activities by a significant margin and dragging down the general health of the U.S. economy.
Section 1031 supporters can also claim that this section promotes fairer taxation. If an investor conducts a 1031 exchange and follows all of the applicable rules, then technically they haven’t “recognized” whatever underlying gains they may have, and so eliminating 1031 would seem to impose an unfair layer of taxation on investors. The U.S. economy would likely see a significant reduction in real estate investment if this provision were to be removed.
Finally, there’s a defensible argument that eliminating like-kind exchanges won’t significantly impact the national pocketbook in the long-term. In an academic study conducted jointly by Professors David C. Ling (University of Florida) and Milena Petrova (Syracuse University), it was noted that a high percentage of like-kind exchanges – perhaps as high as 88% of them – ultimately result in taxable sales. And so removing 1031 exchanges entirely would simply have the undesirable effects of preventing taxable sales and also reducing other related economic activities.
The Resolution: Elimination of Personal Property Exchanges
Lawmakers ultimately chose a middle ground and agreed to eliminate personal property exchanges exclusively from the code. Although like-kind exchanges of real property constitute the bulk of 1031 exchange activity (in terms of overall value), the impact of this change will be significant as many individuals and corporate entities traditionally utilized personal property exchanges on a regular basis. For instance, many companies often used personal property exchanges to exchange company-owned vehicles – such as cars and jets – but now they will no longer have this option.
Although these recent revisions have given Section 1031 an unusually significant amount of attention, it’s reasonable to assume that we’ll see more about Section 103 in the media in the near future. There are myriad potential issues which can arise with a 1031 exchange – such as leasehold affiliate exchanges, related parties, and so forth – and so there’s a high probability that 1031 will show up again soon. The New York tax attorneys here have lots of experience navigating the complexities of the 1031 exchange and would be pleased to assist you with these transactions. Like-kind exchanges can get a bit tricky, and so it’s advised that you consult with a skilled and experienced tax attorney in order to plot the correct course. Contact one of our attorneys online or at Mackay, Caswell & Callahan, P.C. by calling 1-844-MCC-4Tax if you’d like to learn more.