There has been a lot of press lately about tax returns, tax shelters and tax reform. One of the talking points has been 1031 tax deferred exchanges and the notion that this provision creates a loophole for wealthy developers. This perception is inaccurate for a number of reasons.
First, tax deferred exchanges have been in existence since the early 1920s in various shapes and sizes. Congressional records show support for tax deferral treatment with the dual rationale of continuity of investment and administrative convenience. Far from a “loophole,” the current tax code and regulations include specific rules to be followed which limit who can benefit from the structure and which transactions will qualify.
Second, IRC Section 1031 is one of the few reinvestment incentives available to and used by taxpayers of all sizes. Real estate developers that build and sell improved real estate and “flippers” who buy and rehabilitate properties quickly for resale generally cannot take advantage of IRC 1031. The properties owned by these types of taxpayers are considered inventory or “property held primarily for sale” and are specifically excluded from tax deferral treatment under IRC 1031 (a)(2).
Exchange industry data indicates that the majority of exchanges involve properties worth less than $1,000,000. These types of properties are typically those of individual investors and small businesses. Instead of needing to cash out to pay taxes, utilizing a 1031 exchange allows these taxpayers to reinvest their entire sale proceeds to expand their businesses or diversify investment holdings. Like-kind exchanges are integral to the efficient operation and ongoing vitality of thousands of American businesses in a wide range of industries which in turn strengthens the U.S. economy and creates jobs. These businesses—which include real estate, construction, farming, ranching, transportation, equipment and vehicle rental and leasing, and manufacturing—provide essential products and services to consumers and are an integral part of our economy.
A recent study completed by Ernst & Young, LLP, commissioned in response to legislative proposals to repeal Section 1031, documents that elimination of Section 1031 would slow economic growth, reduce GDP and hurt many U.S. small businesses. This study was updated in November 2015 and it quantifies that the segments of the economy supported by the ten most affected industries, including real estate, construction, truck transportation and equipment/vehicle rental and leasing, would suffer an annual year after year decline in GDP of $27.5 billion if IRC Section 1031 were to be repealed. The study further concluded that a repeal of 1031 could lead to a decline in U.S. GDP of up to $13.1 billion annually. You can read more on this study here: http://www.1031taxreform.com/wp-content/uploads/EY-Report-for-LKE-Coalition-on-macroeconomic-impact-of-repealing-LKE-rules-revised-2015-11-18.pdf
In a 2015 study, David C. Ling, professor of real estate at the University of Florida's Hough Graduate School of Business, and Milena Petrova, an assistant professor in real estate in the Whitman School of Management at Syracuse University, found that repealing like-kind exchanges would increase taxes for thousands of commercial property owners, reduce property values, increase rents and result in a decline of real estate activities. Their study concluded that the immediate recognition of gain upon the disposition of property being replaced would impair cash flow and could make it uneconomical to replace that asset. This study further found that taxpayers engaged in a like-kind exchange make significantly greater investments in replacement property than non-exchanging buyers. The complete study can be found here.
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