Section 1031 ‘Like-Kind Exchanges’ Under Attack

Regardless whether your clients are savvy investors or casual homeowners, when President Barack Obama and Congress start talking seriously about “tax reform,” it should grab the attention of all Realtors® and their clients.

“While most observers believe the two parties are too far apart to pass a comprehensive overhaul of the entire tax code, there does seem to be a lot of common ground on reforming the parts of the law affecting how businesses are taxed, “ observed  Ken Wingert, Government Affairs Representative for the National Association of Realtors®.

Current tax policies provide significant tax advantages to buyers or sellers of property compared to any other investment alternative. 
  
For instance, homeowners can deduct mortgage interest payments from their income tax, and when selling their principle residence they can exclude the first $250,000 of capital gain (or $500,000 if they are married). 
   
However, for residential rental or commercial property investors, the payment of capital gains taxes is not excluded. At best those payments can only be postponed by “exchanging” the sold property for a replacement investment in “like-kind” property. 
 
How to do that has been spelled out in specific detail since 1921 in Section 1031 of the U.S. Tax Code, and those details need to be followed exactly to ensure that the exchange qualifies. Typically a “qualified intermediary” is used to ensure that all the steps of “a 1031 exchange” are followed to qualify for the deferral.

As a “Certified Exchange Specialist,” Bill Horan owns the Realty Exchange Corporation, a qualified intermediary. His firm has handled thousands of 1031 exchanges, primarily around the mid-Atlantic area, ranging from $30,000 lots to $26 million office buildings. The bulk of his clients are the “mom and pop” variety, moving from one investment property to another. 

“They are the ones who will be hurt by these proposed changes,” Horan predicted.

“A 1031 exchange is part of our tax law which recognizes that it is unfair to tax business investors who are not realizing a capital gain when the proceeds are immediately reinvested in new, different, but like-kind replacement property,” he explained.  “Postponing the tax encourages economic activity,” Horan added.

The like kind properties are not required to be identical kinds of properties, as long as they are used for investment or business purposes.  For instance, a residential rental property could be exchanged for a retail strip mall, or a tenant-in-common interest in an apartment building could be exchanged for a gas station or even up to three gas stations, but all the properties must be located in the United States. If the replacement properties are valued at less than the sold properties, the investor would pay capital gains taxes on the difference.

“NAR advocates for responsible tax reform that provides the best opportunities for economic growth and job creation, and views these proposals as significant threats to real estate.”

“Elimination of Section 1031 would result in a tax without the investor realizing any money in his pocket,” said Ken Ulsaker, managing broker for Long & Foster’s Commercial Division. “All the proceeds are being reinvested in like-kind property.”

During the last Congressional session, major tax reform legislation introduced in both the House and the Senate, along with President Obama’s fiscal budget, would have repealed Section 1031’s deferral provisions, lumping them in with other current laws viewed as “tax loopholes for the wealthy.”  

The release of President Obama’s current budget on February 2 again proposed capping the deferred amount at $1 million in a calendar year, while also eliminating the provisions entirely for the exchange of “art or collectibles.”

NAR has been active in combating these proposals.

“NAR advocates for responsible tax reform that provides the best opportunities for economic growth and job creation, and views these proposals as significant threats to real estate,” Eric Stackley, Legislative Policy Representative for NAR, explained. 

NAR argued that repeal of the 1031 exchange provisions would have the undesired effect of “locking up” real estate assets in the hands of current owners. Its repeal could discourage the sale of existing real estate to new owners who could invest in job-creating improvements. The 1031 exchange program can help increase the value of the property thereby increasing the property tax revenues to state and local governments.

NAR’s Senior Policy Representative for Federal Taxation Evan Liddiard admits there is little solid data existing on the economic impact of eliminating the Section 1031 exchange provisions. “That’s why NAR is helping fund two studies aimed at answering those questions,” he explained. The studies are due to be released in spring 2015. 

“Like-kind” property exchanges have increased rapidly in recent years. This tool has been used by corporations to defer taxes on property such as rental car fleets or heavy construction equipment. In their analysis last session, Congress valued the current deferral provisions at nearly $50 billion in lost tax revenue over the next 10 years. 

A key player in future congressional deliberations will be Virginia Senator Mark Warner, who was appointed last year to the Senate Finance Committee, which has jurisdiction of any Senate bill that might emerge. So far, Warner has taken a cautious approach to the issue. “We need to have tax reform to make America more competitive in a global marketplace, but we also must be careful that we don’t disrupt key parts of the economy like commercial real estate,” he said.

“It’s important for Realtors® to take the opportunity to educate their members of Congress on the importance of these provisions that shape commercial real estate decisions,” Lilliard advised. “There’s a saying on Capitol Hill that if you’re not at the table, you’re on the menu.”

Visit 1031taxreform.com to learn more or to make your voice heard on Capitol Hill.

Frank Dillow was the 2014 chair of NVAR's Realtor® Commercial Council and is a vice president in Long & Foster's Commercial Division.