Saving the 1031 Exchange
Don’t look now, but some members of Congress are crafting a bill that would do away with 1031 exchanges, instead adopting a new bill that would only benefit the largest of corporations.
It’s a travesty and it’s time for the American people to band together to save the 1031 exchange before it’s too late.
What is the 1031 Exchange?
As finance expert Tuan Pham explains, “A ‘1031 exchange’ is the nickname used to discuss Section 1031 of the U.S. Internal Revenue Service’s tax code. This section states that if an individual exchanges one investment property for another via a 1031 exchange, they may be able to defer capital gains (or losses) that they would otherwise have to pay at time of sale.”
Section 1031 of the IRS tax code also refers to property outside of real estate -- such as business assets -- but this is by far the most commonly used reason for enacting a 1031 exchange.
While everyone should be for tax code reform -- and that’s Congress’ primary intent -- it would be catastrophic and foolish to reform at the expense of the 1031 exchange, which benefits millions of people on an annual basis.
What Repealing the 1031 Exchange Would Mean
According to a recent economic analysis -- "The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate," authored by renowned finance professors David Ling and Milena Petrova -- Section 1031 is more important to the American economy than most people realize.
The study analyzed 1.6 million real estate transactions from 1997 to 2014, which had a combined volume of $4.8 trillion. “In short, despite the claims made by those arguing that eliminating like-kind exchanges would bring in more money to the federal government, the study shows that tax-deferral in the commercial real estate sector is temporary, leading to greater tax revenues than otherwise would have occurred because of the increased value created in real estate,” says Aquiles Suarez, VP for Government Affairs at NAIOP, the Commerical Real Estate Devlopment Association.
The study also found that taxpayers who use the exchange, on average, acquire replacement properties that are $305,000 to $422,000 more valuable than the relinquished properties. Taxpayers also tend to assume less debt, which obviously creates positive financial ramifications in other areas of the economy.
But how specifically would a repeal of the 1031 exchange impact this country? According to Savethe1031.org, it would have a negative impact on taxpayers, homeowners, business owners, employees, real estate professionals, investors, farmers, securities representatives, business brokers, REITs, and everyone in between.
The argument for opponents of the 1031 exchange is that eliminating the tax-deferral mechanism would increase tax revenue, but as the aforementioned study has shown, the increases would come at the expense of a long list of negatives. Home values would drop, as would the number of transactions. All of these factors combined would put a strain on the economy and leave many homeowners upside down on their mortgages.
“The biggest impact would be felt in the Western and Southwestern United States, where nearly 80 percent of all 1031 exchanges from 1997 to 2014 took place,” Suarez says. “But the effect on commercial real estate industry and the overall economy would be nationwide. The resulting negative impact upon and disruption of real estate markets far exceed the cost savings claimed by repeal advocates.”
Even people who don’t own real estate would feel the effects. The Ling-Petrova study shows that rents would need to increase 8 to 13 percent before new construction would again become viable. For families with household incomes of $20,000 or $30,000, an increase like this would be devastating.
But it’s not just the real estate industry that would be affected. Businesses, in general, would be hurt by a repeal of the 1031 exchange. As it stands now, the code allows taxpayers to sell their businesses for installment notes instead of cash. This lets them defer gains and losses until the notes are paid.
A repeal would have devastating implications for capitalism and entrepreneurship.
We the People Must Speak Up
The tax code is overly complex, petty, and restricting -- that much is true. But the 1031 exchange is one of the few positives on a long list of terrible tax laws. Certain senators and members of Congress are attacking the 1031 exchange and claiming that it only benefits the upper echelon of the one percent, but this isn’t true. Anyone with ties to real estate or business is positively impacted by the deferral benefits of the exchange.
It’s time that we stand up for entrepreneurship, capitalism, and freedom from superfluous taxes. It’s time that we gather together, reach across the aisle, and make it a point to tell Congress that we stand for the inclusion of the 1031 exchange in the United States tax code.