As we all know, Section 1031 was preserved in the 2017 Tax Cut and Jobs Act (JCTA), but only for real property assets. Personal property assets, such as machinery, equipment, vehicles, rolling stock, aircraft, collectibles and artwork, no longer qualify for tax-deferral treatment under Sec. 1031. As to real estate, none of the rules have changed, so business as usual for dirt exchanges.
However, for those of you that haven’t been living and breathing new Section 199A of the revised Internal Revenue Code, there is an esoteric, but important, issue involving qualified assets acquired through a Section 1031 like-kind exchange.
Section 199A was designed to achieve some level of rate parity between pass-through businesses and corporate businesses. It permits a pass-through business to deduct up to 20% of it its qualified business income, but the deduction is limited to the greater of 1) 50% of wages paid by the business OR 2) 25% of wages paid plus 2.5% of the “unadjusted basis immediately after acquisition” of all qualified property, for which the depreciable life has not ended. Since real estate is a capital-intensive business, with not a lot of employees / wages paid, real estate businesses will likely be looking to option 2, using the 2.5% capital limitation calculation.
The 2017 tax law requires the U.S. Treasury Department to issue guidance defining the expression “unadjusted basis immediately after acquisition” as it relates to qualified assets acquired through a 1031 exchange, so that taxpayers will know how to calculate the Sec. 199A deduction.
Our IPX1031 General Counsel, Suzanne Goldstein Baker, who also serves as Co-Chair of the FEA Government Affairs Committee, has been involved in drafting comments to Treasury encouraging them to take a plain language approach. The comments recommend that “unadjusted basis immediately after acquisition” should be defined as cost basis, regardless of whether the asset was acquired through a straight purchase or as replacement property in a Sec. 1031 exchange.
Using any other methodology, such as a blended method, that would refer to the original investment into the relinquished property plus new investment into the replacement property, but omit the value of the gain that was not recognized, would result in a significant reduction in the 199A income tax deduction available to taxpayers that did a like-kind exchange.
Our position is that Sections 199A and 1031 serve distinct policy purposes. Section 199A exists to provide rate relief to pass-through businesses akin to the lower rate now enjoyed by corporations, and Section 1031 is designed to promote capital formation and stimulate transactional activity. These two sections should not be conflated in a manner that disadvantages one over the other. Given that a corporation will continue to enjoy a 21% income tax rate if it does an exchange, the pass-through entity taxpayers that Section 199A was designed to help should not be penalized for their decision to take advantage of Section 1031.
Fourteen associations, including our industry association, the Federation of Exchange Accommodators (FEA), signed the comment letter, which you can read HERE. Last week, Suzanne and several members of this coalition met with members of Treasury’s Office of Tax Policy to discuss these comments and make the case for taxpayer-friendly simplicity in resolving this issue. We were told that guidance on several issues related to Section 199A will be forthcoming later this summer, but our issue may not be included in this first round of proposed regulations.