The 26 U.S. Code Section 1031 has been around for a while — for 100 years, to be exact. Yet, through the years, this Internal Revenue Code section has been in the crosshairs of various presidential administrations and congress, owing to claims that, by deferring taxes on capital gains, that investors are somehow getting away with something.
The Biden administration is the latest to fall prey to this idea, indicating that businesses and investors involved with like-kind exchanges will avoid paying $19.55 billion in taxes during the next decade. Such numbers have prompted the White House to propose paring down the 1031 exchange and using those potential “billions” to help fund the $2 trillion American Families Plan.
In actuality, the like-kind exchange is misunderstood. It offers a huge economic impact, adding $55 billion annually to the GDP and creating half a million jobs.
Furthermore, what the White House fails to take into account is that the 1031 exchange process actually generates a great deal of tax revenue; revenue that far exceeds the $19.55 billion anticipated if Section 1031 were to be eliminated in its entirety. It’s important to keep in mind that this forecasted revenue is well above what might actually be generated by the White House proposal. The Biden plan seeks to limit the 1031 exchange benefit to $500,000 per individual ($1 million per couple). As a result, the tax revenue “saved” by limiting the benefits of a 1031 exchange under such conditions would actually be far less than the above-mentioned figure.
The like-kind exchange is in no way a tax loophole or tax avoidance program. It’s a deferral program. Furthermore, the process of exchanging from one property into another helps generate both direct and indirect tax revenues, especially at a more local level where it can presumably more effectively and directly assist communities.
Business, Suppliers and Consumers
First, a brief synopsis of the like-kind exchange. An investor—such as a business—decides to dispose of a real estate asset, called a relinquished property. Under the rules of the 1031 exchange, that business:
- Has 45 days to identify a replacement property of greater or equal value
- Has 180 days to close on that replacement property
- Must ensure all proceeds and expenditures are handled through a qualified intermediary
In such a scenario, the capital gains (the difference between the relinquished property’s basis and its ultimate sales price) are not immediately taxed.
This does not mean, however, that the business involved in the 1031 exchange doesn’t pay ANY taxes. According to a recent paper on the economic impacts of the 1031 exchange, authored by Professors David Ling and Milena Petrova, that business will eventually sell the replacement property through a fully taxable sale. The capital gains taxes on that sale will be higher than if that business sold the relinquished property to begin with and paid the initial capital gains taxes.
Why is this the case? The business puts more capital into improving the replacement property, thus increasing its overall value and sales price.
Furthermore, businesses making use of like-kind exchange rules pay their own share of other taxes. An EY analysis notes that the total direct taxes generated by businesses involved in the process amount to $3.1 billion annually. And this doesn’t even include taxes generated from other factors such as:
- Industry businesses and activities dedicated to the execution of 1031 exchanges.
- Related consumer spending involved with a like-kind exchange.
All told, the annual estimated direct and indirect taxes generated through the like-kind exchange totals $7.8 billion. This means that, over the course of the next decade, all things being equal, this tax generation will total $78 billion.
But wait, there’s more. Specifically, foregone depreciation.
Depreciation works on what could be classified as a “sliding scale,” in that the business can deduct a higher amount against income at the beginning of property ownership. However, the business exchanging into a replacement property must forgo the standard depreciation deductions otherwise claimed on a replacement property acquired through a fully taxable transaction.
This is because the replacement property’s deductions are calculated on the cost basis of the original replacement property, rather than that of the relinquished property. Less depreciation means more generated tax revenue, a concept known as foregone depreciation. This leads to an annual average of $6 billion generated for taxes.
If we spread this out over the next decade, we’re looking at $60 billion in taxes from foregone depreciation. Added to the above-mentioned numbers, the total tax revenue generated from 1031 exchange activities over the next 10 years totals $138 billion!
Additionally, EY analysts point out that their modeling is based on 2019 numbers and acknowledge that greater activity over the past two years could lead to more tax revenue than what was stated above.
Tax Revenue and 1031 Exchanges
So, to conclude, the like-kind exchange has been dubbed a “loophole” and “tax-avoidance plan” by its opponents for many years. In truth, the 1031 exchange process generates a fair share of tax revenue for the U.S. Treasury. It also provides many additional benefits, including less debt and higher capital liquidity.
As such, it’s important that, when examining the tax consequences and benefits of the 1031 exchange, the whole picture is taken into account. An additional $19.55 billion in the national coffers sounds enticing, but at the cost of $138 billion? Not so much.