In: Accounting
H.R. 1 has changed like-kind exchange treatment to allow 1031 to apply only to exchanges of real estate. Read the following article that explains the history of 1031 and lists some pros and cons of 1031 treatment.
Do you think the
changes to 1031 which were included in H.R. 1 address the concerns?
Should 1031 have been repealed entirely? Should it not have changed
at all?POINT & COUNTERPOINT To Repeal or Retain Section 1031: A
Tempest in a $6 Billion Teapot
By Bradley T. Borden, Joseph B. Darby III, Charlene D. Luke &
Roberta F. Mann* This article is a condensation and summary of the
“Lincoln–Douglas Debate on Whether to Repeal Code § 1031” held at
the Teaching Tax Committee meeting at the 2015 ABA Section of
Taxation Midyear Meeting in Houston, Texas. The debate itself was
lively and fun, and raised numerous interesting and provocative
points on both sides of the issue. The authors thank Stephen
Breitstone for filling in at the last minute to participate in the
debate. The arguments for and against repeal are presented in
article format here, but the authors are not in full agreement with
respect to each argument. To retain, repeal, or reform? These are
the questions section 1031 invites. This brief article attempts to
lay out the competing arguments in favor of each of the first two
questions and then explores the two most prominent reform
alternatives. If each of the four authors were to have individually
stated their views as to each question, readers would be faced with
twelve essays. Instead, they have combined and condensed their
argument into four parts: (1) a short history of section 1031; (2)
the arguments in favor of repeal; (3) the arguments against repeal;
and (4) potential avenues for reform.
Short History of Section 1031 The first “modern” income tax law was
adopted by Congress in 1913, and the first antecedent to section
1031 was enacted eight years later, in 1921. The original provision
was broader in scope than present-day section 1031, providing that
no gain or loss would be recognized on an exchange of property if:
(1) the property received did not have a readily realizable market
value or (2) the property transferred was held for investment or
for productive use in a trade or business and exchanged for
property of a like kind or use. The provision allowing
non-like-kind exchanges of property was soon eliminated in 1924,
and since then the like-kind exchange rules have remained
substantially intact, with the legislative tweaks described below,
for almost 100 years. The law itself was substantially unchanged
from 1924 to 1984, but during that period a significant body of
section 1031 case law developed. Perhaps most importantly, the
courts fleshed out the parameters of the section 1031 exchange
requirement. They held that multiple-party transactions could
satisfy the statutory requirement only if the exchanger was not in
actual or constructive receipt of the exchange proceeds.
Consequently, most multiple-party exchanges required a facilitator.
In response to the Ninth Circuit’s 1979 holding in Starker v.
United States that a transaction qualified as an “exchange” even
though there was a two-year gap between the transfer of the
relinquished property and the receipt of the replacement
property,
* Bradley T. Borden, Professor of Law, Brooklyn Law School,
Brooklyn, NY; Joseph B. (Jay) Darby III, Partner, Sullivan &
Worcester LLP, Boston, MA, and Adjunct Professor of Law, Boston
University School of Law; Charlene D. Luke, Professor of Law,
University of Florida Levin College of Law, Gainesville, FL; and
Roberta F. Mann, Loran L. Stewart Professor of Business Law,
University of Oregon School of Law, Eugene, OR. Note that Jay Darby
dissents from the section covering the arguments favoring repeal,
concurs in the section covering the arguments against repeal, and
concurs in part and dissents in part with respect to the section
covering potential avenues for reform.
18 I ABA SECTION OF TAXATION NEWSQUARTERLY
Congress enacted section 1031(a)(3) in 1984. That provision allows
for deferred exchanges that satisfy the identification and exchange
timing requirements. The 1984 legislation also prohibited the
application of section 1031 to exchanges of partnership interests.
In 1989, Congress added section 1031(f), limiting the benefits of
like-kind exchanges between related parties, and section 1031(h),
treating U.S. property as being not of like-kind to foreign
property. Administrative regulations and rulings have also actively
contributed to the law under section 1031. In 1991, the Service
issued extensive regulations that created exchange safe harbors,
including the qualified intermediary safe harbor, to help
exchangers more easily accomplish transactions that the Service
deemed to come within the section 1031 definition of exchange. The
Service also provided substantial guidance on how to structure
reverse exchanges, improvement exchanges, leasehold improvement
exchanges, and program exchanges with certainty that the Service
will not challenge the application of section 1031 to such
transactions. The Service also provided
specific guidance about the nature of tenancy-in-common interests
and interests in certain statutory trusts that hold real estate.
With that guidance, exchangers can be comfortable that a long-held
fee interest in real property can be like kind to an interest in a
properly structured Delaware statutory trust held by numerous other
owners throughout the country. Needless to say, the current
application of section 1031 is significantly different from its
application in 1921 when its predecessor became part of the law.
Every exchanger must report like-kind exchanges on Form 8824.
Published data from recent tax years reveals that individuals file
more than 60% of all filed Forms 8824. Corporations account for
about 30% of filed returns, but they account for almost 60% of all
reported deferred gain. The table below summarizes these numbers.
Arguments in Favor of Repealing Section 1031 An effective tax
provision should be equitably distributed, minimize economic
distortions, and be easy to administer. Section 1031 arguably fails
to meet any
of these classic tax policy criteria. It can be asserted that it
disproportionately benefits wealthy taxpayers, causes
overinvestment in qualifying property, and has created massive
administrative complexity. While section 1031 may have served a
valid purpose when first enacted, it arguably has evolved into an
entrenched, expensive, undeserved, and unnecessary benefit. Recent
Calls for Repeal In 2010, the so-called “Volker Report” presented
the repeal of section 1031 as an option for reforming the tax
treatment of capital gains. Republican Chairman of the House Ways
and Means Committee David Camp proposed repealing section 1031 in
his comprehensive tax reform discussion draft. Democratic Chairman
of the Senate Finance Committee Max Baucus proposed repealing
section 1031 in his discussion draft on tax reform of cost recovery
and accounting. President Obama’s 2015 Budget proposed limiting
section 1031 gain deferral to $1 million per taxpayer per taxable
year, which was estimated to reduce the budget deficit by an
estimated $18.27 billion over the years. News reports, such as an
article in The New York Times last January about
POINT & COUNTERPOINT I TO REPEAL OR RETAIN SECTION 1031
continued from page 1
Form 8824 Data for Tax Year 2011 (All money amounts are in
thousands of dollars)
Individuals Corporations Partnerships Number of Forms 8824 170,268
82,314 22,064 Item Line No. Amount Amount Amount FMV of other
property given up 12 $289,416 $430,345 $726,115 Adjusted basis of
other property given up 13 $68,974 $205,219 $34,677 Gain (or loss)
recognized on other property given up 14 $220,442 $225,127 $691,439
Cash received, FMV of other property received, plus net liabilities
15 $1,787,432 $1,914,721 $1,408,502 FMV of like-kind property
received 16 $15,311,387 $35,229,605 $15,107,374 Adjusted basis of
like-kind property given up 18 $12,377,383 $15,110,927 $9,198,798
Realized gain (or loss) 19 $4,721,435 $23,711,560 $10,132,650
Ordinary income under recapture rules 21 $52,829 $2,651,711
$279,086 Recognized gain 23 $849,498 $3,142,592 $918,758 Deferred
gain (or loss) 24 $3,871,938 $20,601,736 $9,213,893 Basis of
like-kind property received 25 $11,439,449 $17,114,754
$12,269,709
Source: Internal Revenue Service, Statistics of Income
Division.
SPRING 2015 I 19
major American companies “pushing the boundaries” of section 1031,
have fueled the appetite for repeal. To be sure, budget estimates
may show partisan bias, but the scope of the number utilized by the
Obama administration at least provides a sense of the maximum
expenditure represented by current law. Inequitable Distribution of
Section 1031 Benefits Section 1031 is the third largest corporate
tax expenditure, estimated to reduce revenues by $11.7 billion in
2014. Supporters of section 1031 may argue that if it is repealed,
taxpayers will simply use other strategies like investment in real
estate investment trusts, holding property in partnerships, or
cross-renting arrangements. However, these arguments do not support
retaining section 1031, although they may support reform of other
provisions. There is little data on the distributional impact of
section 1031. However, various studies show that the preferential
tax rate for capital gains disproportionately benefits the
wealthiest of taxpayers. For instance, the Congressional Budget
Office estimates that taxpayers in the top 1% receive 68% of the
benefit of low tax rates on capital gains and dividends, while the
bottom 80% will receive only 7%. As section 1031 allows tax
deferral upon the transfer of investment property that would
otherwise frequently produce capital gains for individuals, it is
likely that section 1031 benefits the same sort of taxpayer.
Section 1031 is unlikely to benefit small investors because the
gain deferral would not be enough to offset the costs of the
exchange, which generally include hiring an accommodator to
facilitate the exchange. Additionally, the transaction cost of
hiring an accommodator would be a larger percentage of the tax
benefit gain on the exchange of lower-value property. Finally, the
data from Form 8824 shows that corporations derive the greatest tax
benefit from section 1031,
suggesting that the benefit goes to the largest taxpayers.
Overinvestment in Like-Kind Property Causes Economic Distortion
Section 1031 encourages reinvestment of exchange proceeds in
property that is like kind to relinquished property. Thus, section
1031 encourages what might be called “asset-type lock-in effect.”
For instance, exchangers lock in to holding real estate, if their
initial investment was in real estate. Without section 1031, those
same investors might diversify their holdings. By encouraging
reinvestment in like-kind property, section 1031 may artificially
inflate the value of property that qualifies for section 1031
treatment. Any inflated values affect investor decisions and
further distort economic behavior. Calls for retention of section
1031 come loudest from the real estate and qualified intermediary
industries. They predict disaster and economic collapse if the prop
of section 1031 is removed. These predictions are undoubtedly
biased. The Federation of Exchange Accommodators (FEA), an industry
group representing section 1031 exchange accommodators, argued that
the Joint Committee on Taxation (JCT) estimates of revenue lost to
like-kind exchanges in 2010 were overstated, based on a survey of
their customers. JCT’s 2010 estimate of the revenue loss from
section 1031 was $2.1 billion. The actual deferred gain based on
Forms 8824 filed in 2010 was $40 billion, which, if one were to
calculate tax savings using a conservative 15% capital gains rate,
would translate to $6 billion of revenue loss. As there was likely
some recapture and higher rate capital gain in the mix, the JCT’s
estimate rather than overstating, significantly understated the
revenue loss. One argument is that even though the government loses
revenue when a property owner transfers property and exchanges up
into more expensive property, the government effectively
becomes a partner in the reinvested capital
Pros:
1. Deferral of taxes. A 1031 Exchange allows you to sell your investment property and reinvest in a replacement property in order to defer ordinary income, depreciation recapture and/or capital gain taxes.
2. Leverage and increased cash flow for reinvestment. By deferring taxes, you will have more money currently available for investment. This increased purchasing power gives you the extra leverage to acquire.
3. Relief from management. If you own a property or several properties burdened with extensive maintenance costs and requiring intensive management, you may exchange and replace property for others with less responsibility (e.g., having an on-site manager).
4. Wealth and asset accumulation. One could exchange into numerous investment properties over the years and pass those investments on to their children at the time of their passing.
Cons:
1. Multiple procedures, rules and regulations to follow. If these regulations are fully complied with, no income will be recognized at time of the commercial property exchange transaction. Not strictly adhering to these regulations, however, could doom your tax status and in fact you could incur certain penalties.
2. Difficulty in meeting IRS rules and regulations. Not surprisingly, investors frequently hit roadblocks when trying to comply with 1031 Exchange regulations. A common problem is finding a replacement property within the first 45 days after the sale of your relinquished property.
3. Reduced basis on property acquired. Due to the exchange, the replacement property’s tax basis is reduced. Tax basis of the replacement property is essentially the purchase price less the gain deferred on the sale of the relinquished property as a result of the 1031 Exchange transaction. Thus, if a real estate investor ever sells their replacement property, the deferred gain will be taxed.
4. Losses cannot be recognized. Just as applicable taxes are deferred, losses are also deferred. In a windfall profit year, for instance, deferring losses that could have offset large profits could be a painful decision.
5. Future increases in tax rates. If you go to sell your investment property in the future, you may recognize higher capital gains rates and other tax hikes as we have seen this year.
6. Only tax deferred, not tax-free. Remember, this is a tax-deferred transaction, not tax-free. Should you decide to sell, your tax liability will be fully recognized.