UPDATE 1/17/2017: The 1031 Exchange is in serious danger of being repealed. Kevin Brady, the chairman of the House Ways and Means Committee, and his team are actively proposing the elimination of both business interest deductions and the 1031 Exchange in favor of a new investment expensing that would primarily benefit the largest corporations and the wealthiest 0.01% at the expense of the majority of Americans. As Congress continues the important and difficult task of reforming our tax code, they must hear from voters that the 1031 Exchange is important to the American people.
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The 1031 exchange allows real estate owners to defer capital gains taxes on the sale of investment property so long as property of like kind is acquired according to certain rules. Last November, Senate Finance Committee Chairman Max Baucus (D-Mont.) proposed the largest overhaul of the United States tax code since 1986 by introducing three “Staff Discussion Drafts.” The third discussion draft included the proposal to completely repeal the provisions in the code that allow capital gains taxes to be deferred utilizing like-kind exchanges such as the 1031 exchange. If enacted, the repeal would apply to exchanges occurring after December 31st, 2014. The proposal would also lengthen the depreciable life of real estate to 43 years and bring the depreciation recapture tax into alignment with ordinary income tax rates. An official bill has yet to be introduced.
Proponents of revoking a tax-deferral mechanism consider this to be an attractive option to potentially increase tax revenue. However, a repeal of the primary provisions that allow for tax deferral will also likely reverse many of the positive effects of the existing legislation that drive significant tax revenue in the first place. Moreover, taxing like-kind exchanges would cause the recognition and taxing of capital gains that taxpayers have not yet realized.
The rationale behind current tax-deferred exchange laws is the same as the rationale behind the non-recognition of other unrealized capital gain. Though a property’s value may increase throughout its holding period, the gain is not realized until the taxpayer sells the property and takes constructive receipt of the capital. Until it is realized by the taxpayer, it is not recognized for tax purposes. Similarly, when a taxpayer exchanges one qualifying property for another, without ever taking constructive receipt of the capital, the realization of gain is deferred. Furthermore, the taxpayer remains in the same tax position as before the exchange: The basis for calculating the gain remains the same, and when a replacement property is eventually sold, the taxpayer will owe federal and state taxes—as well as the depreciation recapture surcharge—on the total amount of gain. Since the gain is deferred, the tax on it is also deferred, according to current laws.
Existing tax deferral legislation treats property in the United States as being like kind but does not provide tax deferral if a domestic property is exchanged for a foreign property. This incentivizes reinvestment in the United States, which may keep more capital in circulation in the United States and increase the velocity of the economy.
Additionally, allowance of tax deferral for like-kind exchanges encourages higher rates of real estate and other transactions, which may exert an accelerating force on economic velocity and increase the number of jobs for residents and taxpayers throughout the country. This, in turn, drives additional tax revenue that may otherwise be lost if a repeal of existing tax-deferral legislation were to pass. If the current allowance for tax deferral through reinvestment into like-kind property is repealed and a taxpayer considering the sale of an investment property faces the same tax burden regardless of whether the proceeds are reinvested in productive assets, there may be little tax incentive to productively reinvest the capital at all.
Therefore, repealing the provisions for like-kind exchanges, such as the 1031 exchange, would be inconsistent with the policy to not collect taxes on gains that are not realized by the taxpayer, and such a move may put a halt to a significant portion of the economic activity that drives employment and investment in the United States. Finally, repealing the 1031 exchange would cause a significant drop in the real estate activity and value that help undergird one of the largest drivers of the nation’s net worth via residential housing. As was the case in the Great Recession, this would impact not only household net worth but also the financial system, as residential housing ultimately collateralizes much of our banking system’s capital.
If you would like to contact Congress with concerns about Max Baucus’ proposal to repeal the provision for tax deferral through like-kind exchanges, please see below:
- Finance Committee Communications Director Sean Neary and Press Secretary Ryan Carey: (202) 224-4515
- Find Your Representatives
- Find Your Senators
If you would like more information on Former Senator Max Baucus’ Cost Recovery and Accounting Discussion Draft, in which the full repeal of the 1031 exchange is proposed, visit the below resources: