This article was reposted with permission by Chris Hamilton, Law offices of Young Wooldridge, LLP. Click here to contact.
This post is the first part of a two-part post describing a vital tax provision, IRC 1031. Part 1 will outline its operation and perceived benefits, while Part 2 will present some of the more common arguments against its use, and describe the misguided reasoning behind current legislative attempts to significantly change or eliminate IRC 1031.
IRC 1031 is a provision of the internal revenue code that allows a taxpayer to exchange one business (or investment) property, for another property of like-kind, without recognizing gain or loss in the process. This provision causes a distinctly different result from a taxpayer exchanging one property for a like-kind property. In the latter sale transaction, the property is sold and the taxpayer pays tax on any gain in the property, and then can purchase a new property – or use the monies received otherwise. Through IRC 1031, a taxpayer is not avoiding the tax entirely, just deferring any gain until the property is sold for cash or a cash equivalent.
This touches on one very important issue in tax and tax policy – when is the best time (for purposes of maintaining federal tax revenue) to tax a taxpayer. Generally, the short answer is when the taxpayer has realized the gain in the form of cash or a cash equivalent, as the taxpayer has liquid property to pay the tax.
IRC 1031 is an extension of this policy – we only want to tax individuals when they realize gain by selling an asset in exchange for cash, because, having received legal tender for the investment, they are best situated to pay the tax, they have received property that can be used to pay the tax.
On the other hand, if a taxpayer exchanges one investment for another like-kind investment the taxpayer is not really in a position to pay the tax – they have received like-kind property of similar value; they do not have cash to pay the tax. Put another way, the individual has not “cashed-out” of the investment yet. This in turn, encourages businesses and investors to invest resources more efficiently without a tax burden as a barrier to such efficient investment.
An excellent but very basic example is a Business Z, located in Town A, on real Property X. Real Property X is not suitable to Business Z, however, the owner of Business Z inherited the property from his parents, so it was available and feasible. However, due to the unsuitability of real Property X for Business Z, it has not realized great success in Town A, but is still valuable real property due to its size. There is another property in Town A, real Property Y, that is quite suited to Business Z and likely to significantly increase the foot traffic and quality of experience for customers of Business Z. It is much smaller than Property X, but similar in value due to its location. Business Z generally has three options, 1.) Find a means of financing and purchasing Property Y, while maintaining property X, which may not be economically feasible, 2.) Sell Property X, pay the taxes on any gain, then use the proceeds to help pay for purchasing Property Y and then obtaining financing for the rest, or 3.) Engage in a 1031 transaction. With 1031, business Z can simply swap X for Y, without paying taxes, and without having to concern himself or herself with financing because this is an exchange and not a sale and purchase. Business Z moves to Property Y and thrives.
This important provision has likely been a significant factor in our economy’s recovery and without question, has been a key part of the real estate industry‘s recovery. Recently this important provision has come under attack from elected officials on both sides of the aisle, in an attempt to foot the bills being generated by the same elected officials, with very little consideration for the practical effect of such a change.
In PART 1 I provided a cursory explanation of the basic functioning of IRC 1031 and the rationale supporting the existence of such a provision. In this post I want to detail the benefits IRC 1031 provides to our overall economy, address the argument that this provision is a “loophole” and identify the present legislative efforts to eliminate the benefits it provides.
Recently, this important provision has come under attack from our elected officials on both sides of the aisle, in an attempt to pay for our massive federal government growth with very little consideration for the practical effect of such a change. The stated purpose of these legislative efforts is to increase federal tax revenue; though it is also probably rooted in the perception of the existence of tax “loopholes” and the malignment of this provision as benefitting only the rich.
First, a loophole is defined as “an error in the way a law, rule, or contract is written that makes it possible for some people to legally avoid obeying it” Therefore, the statement that IRC 1031 is a loophole is akin to saying that the law is incorrectly written, or contains some significant ambiguity that allows persons to bypass the intent and purpose of the law. It is without question that IRC Section 1031 was intentionally drafted. It has existed for almost 100 years, and while it certainly has been re-drafted to clarify its treatment of various scenarios, describing it as unintentional, or failing due to errant language is without factual support. On the contrary, it exists to facilitate free markets without imposing the burden of taxation where people are not cashing out of their investments.
IRC 1031 is based on sound tax policy that facilitates a “free-market” by encouraging business and individuals to choose investments that are the most advantageous to their goals without imposing a barrier of taxation that might otherwise prevent such transactions.
Further, the contention that IRC 1031 only affects the wealthy is an unfortunate mischaracterization that ignores the purpose of the statute. Since its inception in 1921, IRC 1031 has shown us many significant economic benefits that unquestionably benefit taxpayers at all economic levels. Some of these benefits are:
- It encourages investment in U.S. properties and assets due to its express restrictions.
- It allows a taxpayer to exchange business/investment property for like-kind property that would be more productive than property he or she owns.
- It allows a taxpayer to efficiently change geographic locations to respond to growing customer/business needs.
- It allows taxpayers to diversify or consolidate assets held for investment or for use in business.
- It allows a taxpayer to change investments to meet a change in business plan or lifestyle more suitable to the taxpayer’s economic reality.
- It facilitates the existence of businesses that purchase and lease equipment which would otherwise be stymied by the effect of depreciation deductions on equipment, and significant gain that would result to taxpayers.
Further, exchange industry statistics show that sixty percent (60% ) of properties that are exchanged through a 1031 exchange are valued at less than one million dollars ($1,000,000) and more than one-third (1/3) of the properties exchanged are worth less than $500,000.00. Thus, the reality is that while you do have to own an investment property for IRC 1031 to benefit you directly, a lot of low to moderately valued property is exchanged.
Further, given its significant use in modern businesses, the provision undoubtedly benefits both higher and lower income classes as it facilitates the continued operation of businesses. Thus, this perception of 1031 as a “loophole” or the malignment of 1031 as a benefit for the rich is based largely in paranoia that is not rooted in fact.
Likely, it is this point of view, and the frequency of its use that has caused our elected officials to target IRC 1031 for reform. As our federal spending increases, seemingly without limitation and reason, your elected politicians are trying to find new ways to pay that bill. One way they are currently seeking to do this is by eliminating or significantly restricting this critical tax provision which has been in effect since 1921. It is not mere speculation or hype that your elected politicians are seeking new ways into your pockets:
- Former Senate Finance Committee Chairman Max Baucus, (D, Montana) proposed completely repealing IRC Section 1031 in its entirety before he was appointed ambassador to China.
- On the other side of the aisle, Representative Dave Camp (R, Michigan), Chair of the Committee on Ways and Means in the U.S. House of Representatives has released a proposed bill also eliminating 1031 after 2014.
- President Obama proposes places limitations on the amount of capital gains to be deferred.
The reasoning or the purpose of such changes is simple – it is based on a goal of increasing federal revenue. Unfortunately, for the foregoing reasons, this goal will likely not be achieved by limiting IRC 1031 benefits; and in fact, will likely have drastic negative economic repercussions that will further slow our economic recovery.
Given the significant proven benefits of IRC 1031, identified above, it seems more likely to reduce federal income tax revenue, slow down our already anemic economy and impose a significant and disproportionate burden on middle-class taxpayers.
First, astute individuals, businesses and business owners will simply stop engaging in such transactions to maximum extent they can afford to. These businesses will adapt to changes in the tax code and what we will see instead is a slow down of economic activity, because those businesses will be stuck with the property they own and loath to be taxed on relinquishing those properties. As a secondary but related effect, to the extent employers are limited in the growth of their business, this will impact their need to hire and retain employees.
Second, in addition to the general slowdown, to the extent such a change does increase tax revenue with respect to real estate transactions (not an overall increase, but an increase due to the fact that such transactions are taxed) this effect will disproportionately impact the middle class. Wealthy people who hold such property for investment will simply choose not to sell property that they would otherwise be taxed on. On the other hand, the middle class individual – who may be significantly impacted by the recognition of income in selling the few or only properties it has to sell, will not be so situated – that taxpayer will be forced to sell in spite of the negative tax consequences due to the need for cash. Thus, in our short example above involving Business Z, and Town A, the owner will have significantly greater obstacles to gaining title to Property Z, and may be forced to remain on Property Y and suffer the consequences. Make no mistake – a loss or significant restriction of 1031s will have a much larger negative impact on the middle class than it will the wealthy.
In closing, I want to be clear that this is really is not a partisan issue, it is a tax policy issue. Unfortunately, it is being driven by individuals who are not relying on their constituents understanding the effect of the change as a whole, but who are relying on their constituents hearing a “sound bite” that makes them believe a goal is being achieved, or a wrong righted. Therefore, I encourage you to take the time to educate yourself about the tax policy being discussed right now, and to contact your local representative and congressman and voice your concern over this issue. Right now, America is in a critical rebuilding period. We need to encourage investment and growth through real assets versus through credit or debt, and these policies will likely smother any growth that has occurred since 2008.
This article was reposted with permission by Chris Hamilton, Law offices of Young Wooldridge, LLP. Click here to contact.
Note from Edmund & Wheeler, Inc.
The Federation of Exchange Accommodators has developed a website whereby taxpayers can reach out to their elected officials to urge them not to repeal Section 1031. Click here to make yourself heard.