With all the turmoil in Washington, one important proposed tax change has mostly fallen through the cracks: the gutting or outright elimination of the 1031 exchange provision.
Essentially, Section 1031 of the tax code allows those who sell a parcel of real estate and invest the proceeds in a different parcel of real estate to postpone capital gains taxes. The provision dates back to the 1920s, when it helped settle disputes among farmers. In the decades since, it's been extended to apply to other assets such as fleets of vehicles, even patent rights, though real estate still accounts for roughly 36% of 1031 exchanges.
The 1031 exchange “is a great tax strategy for real estate professionals," says Robert Gilman, a partner at Anchin, Block & Anchin, an accounting and advisory firm in New York. "Once you sell a building, you are looking to buy the next one. With a 1031, you can use all the proceeds from the sale. If you had to pay the taxes … you would only be able to reinvest approximately 65% of the proceeds."
Why would legislators want to do away with this tax deferral? It's a long story. "If you look at fairly recent history, you can see evidence of multiple proposed 1031 repeal attempts," says Brent Lindell, Wisconsin market manager at Savant Capital Management in Madison. He lifts examples from Republicans and Democrats—yes, even during the Obama administration. "Given the number of tries to make this happen—unsuccessful tries, I might add—I really don’t foresee this happening anytime soon," he adds.
Yet the idea has resurfaced recently. "There's a real interest in cutting tax rates, and to offset some of that revenue loss, legislators keep proposing to close loopholes," says Steven Rosenthal, a senior fellow at the Tax Policy Center, a Washington, D.C.-based nonpartisan, nongovernmental research organization and a joint venture of the Urban Institute and Brookings Institution.
The Section 1031 exchange is viewed by many as a loophole, he adds, though advocates insist that it merely provides tax deferral, not tax exclusion.
If the rule is capped or repealed, who will be the winners and losers? "The winners will be those who end up paying less in taxes, if tax rates are cut. The losers will be the real estate sector, principally," says Rosenthal.
Indeed, the repercussions could be drastic and far-reaching. The 1031 exchanges “directly benefit millions of American businesses and investors each year," says Zev Fried, managing director at Los Angeles-based JSF Financial. "Losing this benefit may discourage real estate investors from swapping their current investments for other properties."
Patrick Mitchell, tax partner at Dallas-based Hunton & Williams, agrees. "The impact of repeal of Section 1031 may result in a significant contraction of the invested capital in various market segments," he says. Beyond real estate, he cites corporate aircraft, vehicle leasing companies and conservation easements.
Given the current state of affairs in D.C., it seems unlikely that any changes will happen soon. "At this point, it is overall tax reform we’re still dealing with, not specific legislation aimed at like-kind exchanges," notes John Harrison, executive director and CEO of the Alternative & Direct Investment Securities Association in Indianapolis. But, he adds, if legislators see the elimination of 1031 as "a quick injection to the government of additional tax money"—and one estimate says a repeal could raise nearly $41 billion in additional tax revenue within 10 years—they risk "the long-term consequences of reduced growth, loss of jobs and a hit to the overall economy," Harrison cautions.