Often, when learning of the tax deferral benefits of like-kind exchanges for the first time, sellers are surprised. It seems too good to be true, but it is. Capital gains taxes, recapture of depreciation, state taxes and a health care tax can all be deferred in full. But given the current climate of impending tax reform, is it still advisable?
Baucus and Camp Tax Reform Plans
A number of tax reform plans have been circulating over the past several years. The first of these plans was proposed in November 2013 by Max Baucus, the then-chairman of the Senate Finance Committee. Tax rate-reduction was a key goal of the Baucus plan. Baucus has since left Congress to serve as the U.S. ambassador to China. Later, in February of 2014, Dave Camp, the then acting chairman of the House Ways and Means Committee, sought to reduce the many individual tax brackets to two and dramatically simplify the tax code. Both the Baucus plan and the Camp plan included the elimination of like-kind exchanges as one of their tax reduction measures.
It is worth noting that after the proposals of these plans calling for like-kind exchange repeal, several studies were undertaken to gauge the effects of such repeal. While it might seem that the repeal of Section 1031 would recoup for the government any taxes that would be lost to deferral, these studies concluded just the opposite.
The Economic Impact of Repealing Like-Kind Exchange Rules
The first study, the Economic Impact of Repealing Like-Kind Exchange Rules, was done in 2015 by Ernst & Young. It was a macroeconomic study that found that repeal is at cross-purposes with the goals of tax reform. Remember, tax deferred exchanges are for personal property as well as real estate. When personal property such as equipment, machinery, vehicles, aircraft, railcars, tractor trailers and even franchises are exchanged, there are a myriad of industries supported in producing the replacement assets. The study analyzed the trickle-down effect of like-kind exchanges on all of these dependent industries. On the whole it was found that the repeal of like-kind exchanges adversely affect the whole economy, costing billions of dollars.
The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate
The second study, the Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate, was authored by two college professors, Dr. Milena Petrova and Dr. David Ling. The Ling-Petrova study was microeconomic in nature and focused on the effect that repeal of like-kind exchanges would have on the real estate sector. The 94-page report found that the use of real estate exchanges encourages economic activity that adds federal tax revenue. Keep in mind that Section 1031 provides for tax deferral not tax forgiveness. The authors found that in 88% of the cases studied, investors disposed of properties acquired in a 1031 exchange through a taxable sale. Such disposition results in deferred tax becoming payable. The conclusion summed this up as follows: “This suggests that the cost of Section 1031 is significantly overstated as it ignores the frequency of exchanged properties sold through ordinary sales and the increase in tax liability due to reduced depreciation deductions.”
The Republican Blueprint for Tax Reform
In June of 2016, House Ways and Means Chairman Kevin Brady and Speaker Paul Ryan introduced the GOP “blueprint” for tax reform. The Republican blueprint recommends three tax brackets for individuals and a single rate for corporations of 20%. Simplification would allow tax returns to be filed on a “postcard.” One of the most significant features of the blueprint is that it would allow 100% expensing of the purchase price of business assets. One likely consequence of this immediate write-off would be to lessen the benefit of deferring tax upon the sale of an asset. Like-kind exchanges were not specifically mentioned one way or the other. In addition, 100% expensing would not apply to land without improvements on it.
One thing that all of these plans have in common is tax rate reduction, an outcome that would make like-kind exchanges even more compelling currently. Not only would an exchanger get the benefits of paying taxes later, but at the time payment is made, it would likely be payable at a lesser rate than at the time of the property sale. There is a reason that Section 1031 has remained in the Code since 1921 and there continue to be sound reasons for it to remain under tax reform.