There is no question the real estate world will be significantly influenced by any tax reform passed during the President Trump era. Republicans in the House of Representatives are proposing to eliminate the section 1031 exchange provision from the Internal Revenue Code. While we are not certain that the provision will be eliminated from the tax code, elimination coupled with amended tax provisions have been discussed as a way to effectively lower the capital gains rate.
Section 1031 Like-Kind Exchanges Have a Long History Encouraging Capital Investment and Improvement
This section was added to the Internal Revenue Code in the 1920s as a way to help small farmers exchange land without incurring a burdensome tax on the transfer. The intent behind it was that if the full value of the trade is simply tied up in the land, there is little or nothing on which to pay taxes. Since it was initially enacted, use of this provision has expanded into a wider variety of small and large businesses in almost every other industry, including the airline industry.
It allows a business to defer capital gains tax on business or investment property if the property is exchanged for a like-kind property or investment. The provision is intended to encourage investment by upgrading assets and reinvesting in current assets, and to promote business mobility.
Who currently benefits from using 1031 like kind exchanges?
Since its inception, the provision has benefited an increasing number of industries. Significantly, farmers and ranchers, commercial real estate investors, construction companies, conservation organizations, trucking and fleet transportation owners, and smaller family-owned businesses that invest in real estate and vehicles receive favorable tax treatment under the 1031 provision. However, individual investors are the largest group of beneficiaries under these exchanges.
Why are the House Republicans considering eliminating 1031 exchanges?
The House Republicans’ main rationale for eliminating the provision is that they believe such course could, coupled with other reforms, effectively lower capital gains rates for investors. In place of section 1031, the proposed tax plan would allow businesses to fully expense an investment in real estate or other assets, except for the portion of the purchase that represents any land purchased.
How would investors be affected if 1031 exchanges are eliminated?
Other experts believe that eliminating the 1031 exchange would significantly hurt small businesses, individual investors and targeted industries, such as securitized real estate. These groups would face a higher tax burden and increased pressure to keep obsolete assets. Economists state that by allowing full expensing of capital investments, rather than treat asset upgrades as 1031 exchanges, investors will be forced into holding assets longer than necessary, greatly reducing transactional activity. In turn, they predict a significant slowdown in economic growth across the board.
Will they actually be eliminated?
No one really knows. Experts speculate that if they were to be eliminated, they would have been eliminated under previous administrations and not the pro-business Trump administration. Because 1031 exchanges are viewed as an investment incentive and have been on the chopping block for 25 years, talk of eliminating them may be just that—talk.
Elimination Would Affect Almost Every Industry
Section 1031 like-kind exchanges are typically used in commercial, agricultural and real estate development. However, the securities industry, vehicle and equipment leasing companies, investors in artwork and collectables, nonprofit organizations, owners of motor-vehicle fleets, transportation providers and purchasers of many other qualifying types of assets could be affected.
Because many financial analysts believe that the exchanges have widespread impact beyond just individual investors, eliminating them would reduce investor incentives and motivation to trade up and reinvest in assets. This could cause a significant capital exodus from the United States, slow GDP growth and increase costs to consumers. The real question then becomes, what tax treatment will former 1031 exchanges receive under a new tax provision.
