Section 1031 Like-Kind Exchanges
Section 1031 of the Internal Revenue Code of 1986, as amended, provides investors the ability for federal and, in some cases, state tax purposes, to defer tax on gain from real property held for investment or use in a trade or business that is exchanged for “like-kind” real property also held for investment or use in a trade or business. Any deferred gain will not be recognized for tax purposes until such time as replacement property is sold and not replaced with like-kind property. The receipt of proceeds from the sale of the relinquished property could disqualify the like-kind exchange and cause gain from the sale to become immediately taxable. For purposes of real property like-kind exchanges, most real property will be like-kind to other real property as long as the properties are of the same nature, character or class.
Section 1031 exchanges are accomplished by the direct swap of properties between two parties, by a deferred exchange where a party sells its relinquished property and parks the proceeds with a qualified intermediary until such time as the party has located a suitable replacement property, or a reverse exchange where a replacement property is located prior to the sale of the relinquished property. For deferred exchanges, potential replacement properties must be identified within 45 days after the date the relinquished property is sold, and the replacement property must be received and the exchange completed within 180 days after the sale of the relinquished property or the due date (with extensions) of the income tax return for the tax year of the investor in which the relinquished property was sold, whichever is earlier. Additionally, the replacement property must be substantially the same as the property identified within the 45-day limit. For full tax deferral, an investor must reinvest all proceeds from the sale of the relinquished property in the replacement property and have the same or greater amount of debt on the replacement property, otherwise any proceeds or debt reduction will constitute taxable gain.
An investor may identify more than one replacement property; however, the replacement properties selected must satisfy one of the following three rules: (a) up to three replacement properties may be identified without regard to their fair market value, (b) the value of all of the replacement properties may not exceed 200% of the aggregate fair value of all relinquished properties, or (c) any number of replacement properties may be selected without regard to their combined fair market value, as long as the properties acquired amount to at least 95% of the fair market value of all identified.
By deferring tax on gain from real property investments, investors can grow their wealth by harnessing the full amount of their gain, rather than a net amount after payment of income taxes, for future or additional investments. There is no limit on the frequency of like-kind exchanges.
History Of Section 1031
Tax-deferred exchanges, which originally evolved as a land swap mechanism for farmers, were initially introduced into the Internal Revenue Code in 1921. However, it was an amendment to the Internal Revenue Code in 1954 which resulted in present day Section 1031 for “like-kind” exchanges. Then, in 1979, Starker v. United States expanded the rules to permit non-simultaneous 1031 like-kind exchanges. Subsequently, the Tax Reform Act of 1986 restricted other tax benefits for investors in real property, which increased the popularity of tax-deferred like-kind exchanges. Thereafter, various tax code amendments and regulations and revenue rulings issued by the Internal Revenue Service resulted in additional changes to the exchange rules. One significant example was Revenue Procedure 2002-22, which provided that fractional ownership of real property qualified as like-kind exchange property for purposes of Section 1031 and ushered in a period of tenant in common syndications.
Proposed Repeal Of Section 1031 And Its Potential Economic Impact
Historically, there were three main purposes for the enactment of the like-kind exchange rules: (1) for administrative convenience, (2) to avoid unfair taxation of ongoing investments in property, and (3) to encourage active reinvestment.
Recent congressionally proposed tax reform plans include the use of revenue from a repeal of Section 1031 to finance a lower corporate income tax rate. Additionally, the President’s 2016 budget also proposes a limitation of $1 million per taxpayer per year on real property like-kind exchange deferral. These proposals claim that one reason for the enactment of Section 1031 was administrative convenience and that such ground no longer exists. Some argue that the like-kind exchange process actually results in increased administrative burdens through the litigation, revenue rulings, and promulgation of regulations and procedures, including review and analysis of like-kind exchanges, required of the Internal Revenue Service. However, any purported increased administrative burdens caused by the like-kind exchange process are clearly offset by the overall economic benefits resulting from the availability of tax deferral through the use of Section 1031.
Tax deferred exchanges are based upon the premise that if a property owner reinvests directly into a replacement property and receives no cash or reduction of debt, then he ends up in the same position. In other words, he has essentially traded one property for another and as a result does not have any tangible economic gain in the form of cash or reduced liability. Therefore, it would be unfair to require the property owner to pay tax on a gain which is not economically available at the time of the exchange and rather such tax liability should only be realized when the property owner actually realizes the gain or economic benefit. It is important to note that like-kind exchanges are not tax exempt, they are simply tax deferred, and upon a sale with no replacement property purchased, the property owner becomes liable for tax on any gains. Proponents of the Section 1031 repeal argue that the tax on gain can be deferred by repeated exchanges until death, at which time the basis in the property receives a step-up to fair market value, resulting in an elimination of the gain. While this is accurate, the benefits to the economy during the life of the investment and through the course of various like-kind exchanges, which include increased jobs and opportunity and the best use of assets, significantly outweigh the lost tax revenue resulting from the tax deferral benefits of Section 1031. Additionally, according to a recent study by professors at the University of Florida and Syracuse University, a majority of replacement properties are eventually sold in fully taxable transactions, thereby not taking advantage of a stepped-up basis at death, and taxes paid in a fully taxable sale after an exchange are approximately 19% higher than taxes paid in a fully taxable sale without a preceding exchange.
Section 1031 like-kind exchanges also naturally promote reinvestment in additional properties, thereby creating economic activity both from the sale of the relinquished property and the acquisition of the replacement property. The tax deferral benefit of Section 1031 like-kind exchanges frees up additional capital that can be applied toward investment in replacement property. If this benefit were no longer available, the turnover rate for investments would be significantly decreased due to reduced capital available for such investments and the longer holding period required for investors to attain their targeted rate of return. Proponents of the Section 1031 repeal argue that the continued availability of like-kind exchanges lock-in investments into a specific type of asset, thereby preventing capital from being used in the most efficient manner. Although this may be true, regardless of a repeal of Section 1031, investors will likely seek to invest in what they know and what they are familiar with, and that in itself is a true use of capital in the most efficient manner.
It is estimated that Section 1031 like-kind exchanges are implicated in 30% of all transactions and currently the real estate and equipment and vehicle leasing industries account for approximately 50% of the fair market value of property received in like-kind exchanges. The following illustration from a recent study published in March by Ernst & Young in response to legislative proposals to repeal Section 1031 depicts the industries which would be most affected by a repeal of Section 1031.
The repeal or reform of Section 1031 would have a ripple effect on the economy as a whole. The Ernst & Young study found that a repeal of Section 1031 would result in decreased federal tax revenue of approximately $1.6 billion annually, reduce GDP by $8.1 billion each year, discourage investment, negatively impact the economy as a whole with a concentrated burden on certain industries and be contrary to the stated tax reform goals of economic growth, revenue neutrality and fairness. Additionally, real estate investment companies, which often employ the use of pass-through entities such as limited liability companies and partnerships, would not receive the proposed offset of a cut in the corporate tax rate. In fact, although the repeal of Section 1031 would increase tax revenue by approximately $41 billion over a period of 10 years, the Ernst & Young study found that it would reduce GDP over the same 10-year period by up to $131 billion in the event of an accompanying revenue neutral reduction in the corporate tax rate. The study also found that, even if the tax revenue derived from the Section 1031 repeal is used to finance a reduction in both the corporate income tax rate and the partnership tax rate, GDP would still decrease by approximately $6.1 billion annually.
The proposals for repeal or reform of Section 1031 appear not to be going away and, if successful, will undoubtedly have a profound effect on economic growth. The results of such legislation would include, but not be limited to, a decrease in real estate values and rental rates, longer holding periods and decreased investment turnover, a concentrated burden on certain industries and decreased GDP.