By: James T. Walther, Esq., LL.M. Legal 1031 Exchange Services, LLC
Presidential candidate Joe Biden recently announced his proposed tax plan, which seeks to fund a $775 billion child and elder care plan by making several major changes to the Tax Code, including a repeal or limitation on the “1031 exchange” or “like-kind exchange a tax benefit commonly used by real estate investors.” The Tax Cuts and Jobs Act, passed by the Trump Administration back in 2017, repealed the use of personal property 1031 exchanges to pay for other tax cuts, but they did allow certain accelerated depreciation methods, which sunset over a period of time, to partially offset its elimination. It seems like both political parties do not fully appreciate the benefits that 1031 exchanges bring to the economy. An IRC §1031 Exchange (“Exchange”) allows sellers of real estate held for investment, or used in a trade or business, to defer capital gains tax normally due upon the sale of the property so long as they use the proceeds to buy replacement business or investment real estate within 180-days.
As a result of this recent announcement by the Biden Campaign, I have seen several articles/comments which incorrectly refer to 1031 exchanges as a “tax loophole” or a “tax dodge.”[1] These terms are nothing more than misnomers because 1031 exchanges are a legal tax benefit and are part of the Tax Code. In addition, articles that claim this tax deferral strategy helps investors “avoid paying taxes on equity gains” might provide the reader with the wrong impression about how 1031 exchanges work.[2] I would give the authors the benefit of the doubt and say that they are simply uninformed; however, lately, there appear to be a lot of inaccuracies being thrown around, which appear to indicate a pre-existing bias against the real estate industry, or a misconception that 1031 exchanges only benefit big money investors or corporations. 1031 exchanges are a benefit available to investors big and small and in general have been found to be a net positive for the economy – a benefit that creates more tax revenue than is deferred. Studies have also found that in many cases, all or most of the deferred tax liability is later paid.
1031 Exchanges are not a “tax loophole”:
In a previous article highlighting several misconceptions that investors and professionals have about 1031 exchanges, we emphasized that those new to 1031 exchanges (“it’s too good to be true”), or the uninformed, may question the legitimacy of the process based on bad information.
Exchanges are written into the U.S. Tax Code and have been available to taxpayers in one form or another for almost 100 years. Exchanges have been available in their current structures since 1986 and are not a “loophole” or some “tax magic.” Exchanges are allowed as part of the rules. Here is a famous quote explaining why there is nothing wrong with tax planning if one follows the rules: “Anyone may arrange his affairs so that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.” — Judge Learned Hand, Helvering v. Gregory, 69 F.2d 809, 810 (2d Cir. 1934), aff’d, 293 U.S. 465 (1935). [Excerpt from “10 Common Misconceptions About 1031 Exchanges” James T. Walther, Esq./Legal 1031 Exchange Services, LLC, 2019]
To bolster this point, below is another spot-on quote from Judge Hand reiterating that everyone, wealthy or not, can effectively plan to reduce or minimize tax liability and doing so is not a crime (tax evasion is).
“Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.” — Judge Learned Hand, Commissioner v. Newman, 159 F.2d 848, 851 (2d Cir. 1947)(dissenting opinion).
1031 Exchanges benefit investors big and small and the economy:
In general, even many professionals struggle to understand the basics of the Tax Code, the manner in which tax benefits and incentives boost the economy, and how taxpayers are free to plan and adjust to minimize their tax liabilities. In the case of 1031 exchanges, misinformed or dismissive critics tend to believe that because big money real estate deals stand to benefit the most from Section 1031, while smaller investors do not benefit. This is far from reality.
While a 1031 exchange results in a taxpayer deferring their capital gains tax there are some benefits to the economy which more than offset the tax deferral. Here are the basics:
- A 2015 microeconomic study “The Economic Impact Of Repealing Or Limiting Section 1031 Like-Kind Exchanges In Real Estate” by economists Professor David C. Ling, University of Florida and Professor Milena Petrova, Syracuse University (updated September 2020) found that 1031 exchanges have the following significant benefits: encourage investment; contribute to significant federal tax revenue; lead to job creation; and result in less debt.
- Likewise, a Macroeconomic study by Ernst & Young found that repealing Section 1031 would: result in less federal revenue; shrink the U.S. economy by $13 billion annually; and discourages investment, among other disadvantages.
- Exchanges help businesses grow efficiently and create jobs. Business owners often use a sale lease back and 1031 exchange to liquidate their real estate equity as part of a strategy to expand and open new locations. This is common in many different types of businesses including the quick serve and fast casual restaurant industry, gas stations, and the medical and dental industries. 1031 exchange buyers transitioning out of a more management intensive property often find these stable net lease assets to be an attractive investment and help the seller achieve their liquidation/cash flow goals.
- Many choose to invest in real estate to build wealth in lieu of a formal/traditional retirement plan that they may not have access to; have limited access to; or did not have access to in the past. Using a 1031 exchange to invest in real estate provides investors an opportunity for tax deferred growth with a stable and consistent return.
- Exchanges boost local economies, create jobs, and generate local tax revenue. Exchanges not only defer federal capital gains tax, but also defer most state level tax and “facilitate efficient investment.”[3] A chilling effect on transactions as a result of a repeal would likely lower real estate values, stall or sink some transactions, and have a corresponding effect on local tax revenue. For example less revenue from: transfer taxes; local property taxes; mortgage taxes and bank income; and finally the tax on the income generated for the dozen or so professionals who benefit from a real estate deal – realtors/brokers; finance, insurance, and title professionals; appraisers; attorneys; accountants; and government employees such as recording clerks, revenue agents, and assessors. In addition to stimulating other industries, like construction.
To sum it up: If a taxpayer is following the rules, Section 1031 exchanges are not abusive tax avoidance schemes, but instead, a net positive to the tax revenue collected by the federal and state governments. The 1031 exchange is a tax benefit that plays a crucial role in investment real estate markets and the overall economy and a benefit available to investors large and small. Eliminating 1031 exchanges during a recession that has been extremely hard on real estate investors would make little sense to help stimulate recovery. Proposed repeal or elimination of the 1031 exchange seems to create more questions than it answers. In spite of all the rhetoric out there and those who believe that a 1031 exchange is “a tax dodge” for the wealthy, the net positives have kept Section 1031 in the Tax Code since 1921 and will likely keep it there for the foreseeable future.
[1] See example from The Real Deal “by closing off a loophole used by property investors”; see also “Are 1031 exchanges at risk if Congress closes off the tax loophole?”, OC Register September 12, 2020.The same goes for mislabeling the step-up in basis upon death, it’s a provision of the Tax Code, not a “loophole.”
[2] In fact, the outdated IRS fact sheet (FS-2008-18) linked/referenced by the Real Deal article states that “IRC Section 1031 provides an exception and allows you to postpone paying tax on the gain if you reinvest the proceeds in similar property as part of a qualifying like-kind exchange. Gain deferred in a like-kind exchange under IRC Section 1031 is tax-deferred, but it is not tax-free.” [emphasis added]
[3] Pennsylvania is one of few states that do not completely conform to the federal tax code version of Section 1031. In recent legislation that sought to recognize section 1031 to promote small business growth, the introductory memorandum stated “Under Federal tax law, a “like-kind” exchange under Internal Revenue Code Section 1031 allows for tax-deferral when property is exchanged for similar property. This long-standing Federal provision facilitates efficient investment in the job-creating assets businesses need to remain competitive. Every state but Pennsylvania provides for a similar deferral on the state level (current Pennsylvania tax law contains no such provision).” [emphasis added]
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