As tax reform has hit the forefront of the new Administration’s agenda, this is good time to examine a powerful, yet often misunderstood, provision of the tax code. The tax deferred exchange, as defined in Section 1031 of the Internal Revenue Code of 1986 (as amended) offers investors a great opportunity to build wealth and save taxes. Although often criticized as a tax avoidance mechanism, capital gains taxes are simply deferred until ultimate sale of the property for cash rather than paid currently. By completing an exchange, an investor can dispose of business or investment property and use all the equity to acquire replacement investment property of equal or greater value. This model of exchanging one property for another more valuable property can be done multiple times and tax can be deferred over many transactions.
In a tax-deferred exchange, owners can postpone recognition of gain on property held for business or investment when they swap one property for another of “like kind.” The capital gains tax that would otherwise be due gets deferred until the owner sells the replacement property and receives cash.
Under Section 1031, which has been part of the tax code since 1921, certain types of real property qualify for tax deferred treatment. A rental house in San Jose, California can be exchanged for an investment duplex in suburban Baltimore. Nebraska farmland could be exchanged for rental condos in Seattle. Exchanges also are used for environmental protection objectives such as swapping conservation easements to preserve habitat or to influence future development. They can also be used to trade development opportunities from land that is not suitable for a particular business use to land that is.
On the other hand, fixer-upper houses and other real estate held for short periods and then flipped to new purchasers do not qualify for tax-deferred exchanges, nor do owner-occupied residences. IRC §1031 does not apply to exchanges of stock in trade, inventory, property held for sale, stocks, bonds, notes, securities, evidences of indebtedness, certificates of trust or beneficial interests, or interests in partnerships.
This touches on a very important issue in tax policy. When should a transaction, or series of related transactions, be taxed? For purposes of maintaining federal tax revenue one could argue that the appropriate time is at the conclusion of the transaction when the economic and financial reality is known. But that presupposes that cash is available to pay the tax. In the case of real estate transactions, cash is not always realized in a sale or disposition. So, the better policy is to impose the tax when the gain is realized by selling an asset in exchange for cash. Having received legal tender for the sale of the investment, the seller is best situated to pay the tax.
On the other hand, if a taxpayer exchanges one investment for another like-kind investment, that is, disposes of one property and acquires another, the taxpayer is not really in a position to pay tax on the gain which would be recognized from the disposed property – they have received like-kind property of similar value, not cash. Therefore, 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 without a tax burden as a barrier to efficient investment. This is the underpinnings of 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.
Thinking about this policy from a negative perspective, if it were not for Section 1031, investors would have to pay tax on gain every time they transfer property. Knowing this, an investor would likely consider not selling unless she receives cash sufficient to pay the tax. This would constrict an otherwise free market. If the policy were to tax every transaction regardless of whether it produced cash for the taxpayer, investors and business would feel pressure to hold on to their property rather than sell or trade or otherwise dispose of it. This would result in stagnation of real property turnover and no opportunity for the government to levy a tax, since no transaction took place.
The Trump Administration has just announced its plan for sweeping tax reductions, including capital gains tax rates, with the stated objective to grow the economy. With the of the top capital gains tax rate to 20 percent, it is conceivable that Congress could consider repealing Section 1031 with the idea of replacing lost revenue from tax cuts with revenue from investment property transactions.
However, Gary Cohn, White House chief economic advisor says “Nothing drives economic growth like capital investment.”
According to a recent article in the Wall Street Journal, analysis of previous administrations’ tax reforms provides substantial economic evidence that “lower marginal tax rates provide the biggest growth bang for the buck”. People and companies will change their behavior in response to better incentives. The economy will grow faster and over time revenues will grow faster than without reform.
So, with growth as the objective, doing away with Section 1031 is a bad idea and contrary to good tax policy. For another very good reason, it is extremely unlikely to gain any traction in Congress since any such legislation would have to approved by the President – who is a real estate investor.