The Economic Consequences of 1031 Exchanges: 5 Myths Debunked

Why Repealing the Use of Like-Kind Exchanges is a Bad Idea

Pundits have been commenting on the economic consequences of the Tax Cuts and Jobs Act since it was enacted in 2017, but misconceptions continue to enter the dialogue around “like-kind exchanges.” This is likely due to a lack of understanding regarding the rules found in Section 1031 of the Internal Revenue Code. The like-kind provision allows taxpayers to defer paying certain taxes when they exchange a business or investment property for another investment property of greater or equal value, rather than using the cash for other purposes.  The provision, which addresses the timing of payment rather than tax forgiveness, has been part of the federal tax code for almost a century. The question is: do like-kind or 1031 exchanges only favor the wealthy, and should they be repealed?

Some people believe so. Shifting political power has led to greater regulation of Section 1031. Recent changes to the tax code now limit 1031 exchanges to “real” property or real estate. This means that personal property can no longer be exchanged, including vehicles, machinery and equipment, livestock, artwork, patents and even fast-food franchise licenses. For taxpayers who once utilized like-kind exchanges for personal property, such as collectibles, however, opportunity zones, discussed below, may provide a mechanism to defer some tax liability.

But eliminating 1031 exchanges would not only fail to generate additional tax dollars for the government, it would also stifle domestic economic growth. Today’s column seeks to clarify some of the misconceptions perpetuated by these articles.

Myth 1: 1031 Exchanges Allow Taxpayers to Permanently Avoid Real Estate Taxes

Section 1031 provides a mechanism to defer tax, not to evade or eliminate tax liability. It doesn’t even reduce the amount to ultimately be paid. Like-kind exchanges affect only the timing of when real estate investors pay certain taxes.

To completely defer the payment of certain taxes at the time of sale, 1031 requires that a taxpayer jump through a series of hoops, including:

• Not taking any cash proceeds whatsoever
• Purchasing replacement property of greater or equal value
• Acquiring all replacement property shortly after the first property is transferred
• Ensuring the owner of the new property is the exact same taxpayer as the selling party (i.e., not creating a new company or buying out investment partners)
• Acquiring replacement property that is “like kind” to the relinquished property
• Holding the replacement property for investment or business use, rather than personal use

If the property owner fails to follow any one of these requirements, the taxpayer pays tax on the transaction for the year the investor sells or transfers the property.

Further, even if all of the necessary steps are followed, the tax deferral is only temporary; an overwhelming 88% of properties acquired through like-kind exchanges are later disposed of through fully taxable sales.

And when the sale actually occurs, the tax bill will apply to a more expensive replacement property because the 1031 rules require the new property to be of greater or equal value than the original property.

Myth 2: 1031 Is Bad for the U.S. Economy

While it may seem counterintuitive, 1031 exchanges actually encourage investment, create jobs and stimulate the economy. One reason is the rule that replacement property must be of greater or equal value than the property sold, as discussed above. So businesses and investors are actually “trading up” and investing in more (or more expensive) property than they started with.

The tax deferral also encourages people to sell instead of holding their assets and to invest in capital improvements. For example, if your property has not been renovated in a long time, and you are not able to do so yourself, 1031 provides an incentive for you to sell to a buyer with the means to improve the old property, and exchange into a property that is not in need of updates. Each sale consequently employs a variety of people (e.g., contractors, surveyors, environmental consultants, escrow officers, and public utility workers). These transactions stimulate the economy, in part, because they divert capital gains tax revenue to productive use.

A recent macroeconomic study by Ernst & Young further indicates that repeal of 1031 would also lead to:

• Increased cost of capital
• Reduced levels of investments
• Slower economic growth
• A concentrated burden in those industries that rely heavily on like-kind exchanges
• The long-term contraction in the overall U.S. GDP of approximately $8.1 billion annually.

Section 1031 also keeps money here in America, as only U.S. property qualifies for an exchange.

Myth 3: 1031 Exchanges Favor Developers

Developers rarely use 1031 exchanges. A developer’s real estate is their inventory, not property held for investment, a requirement for use of 1031. Courts evaluating the taxpayer’s intent look at factors such as the purpose for the acquired property, the nature of the taxpayer’s business and their activities related to the property. If they determine that they are in the business of selling real estate, then the property is considered inventory rather than an investment or operational asset. This disqualifies the taxpayer from using 1031 exchanges.

Further, 1031 exchanges can only capture the value of improvements made within 180 days after the sale of the taxpayer’s relinquished property. As significant real estate developments take substantially longer than six months to complete, 1031 does not provide a useful tax shelter for such projects.

Myth 4: 1031 Only Favors the Wealthy

1031 is one of the few incentives available to, and used by, taxpayers of all sizes. Exchanges help individuals, partnerships, limited liability companies and corporations. In fact, 60% of like-kind exchanges involve properties worth less than $1 million. And more than one-third sell for less than $500,000.

Myth 5: The New Opportunity Zone Laws Make 1031 Obsolete

The Tax Cuts and Jobs Act included new tax incentives for certain investments made in economically challenged neighborhoods designated as “qualified opportunity zones”.  While the opportunity zone (“OZ”) provisions and section 1031 both offer a mechanism to defer certain capital gains, they have different purposes and qualifications, and do not afford the same overall tax benefits:

• OZ investments allow the deferral of up to 15% of capital gains taxes through 2026, at which time those taxes become due; 1031 exchanges may completely defer capital gains taxes until the replacement property is sold.
• OZ investments must be made through a qualified opportunity fund, and used for a project located in a designated opportunity zone; 1031 exchanges do not require the formation of a fund, and replacement property may be located anywhere in the U.S.
• Capital gains derived from the money invested in an OZ for 10 or more years may be completely forgiven; capital gains on 1031 property come due at such time as the investor sells for cash instead of further exchanging.
• Capital gains from any type of transaction, such as the sale of stock or collectibles, may be deferred in an OZ investment; 1031 exchanges only defer capital gains from the sale of investment real estate.

Simply put, 1031 is a useful tool employed by a broad cross-section of America, and encourages investment in the US economy.  As with any real estate investment, it is wise to consult with your own personal tax advisor to assess whether a 1031 exchange may be beneficial to you.

[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinar: Investing in Commercial Property. This is an updated version of an article published on Jan 9, 2017.]

Read more: Putting off the Tax Collector – The Basics of 1031 Exchange Rules, The Ups and Downs of Residential Real Estate Investments, The Economic Consequences of 1031 Exchanges: 5 Myths Debunked