1031 Tax Reform Updates
Threats to IRC Section 1031
Continuing risks to Section 1031 come from dynamic changes in Members of Congress and in the balance of power. While support for Section 1031 is bipartisan, so are the threats. The JCTA was not revenue neutral, and increased the deficit by almost $1.5 trillion over the 10-year budget window. The COVID-19 pandemic-related stimulus packages have further increased the deficit by trillions more. The ongoing need for revenue to fund existing government expenses as well as new legislative initiatives stimulates the search on both sides of the aisle for “pay-fors” to offset these costs.
Elimination of loopholes. Although not the first to call for this, the Biden presidential campaign has called for elimination of certain tax preferences for real estate and “loopholes,” which are reported to include elimination of Section 1031 like-kind exchanges. We have educated many in Congress, both Democrats and Republicans, that Section 1031 is not a loophole or an abusive tax-avoidance strategy, and that Section 1031 is instead a powerful stimulant to the US economy that creates jobs, but clearly, this is an ongoing challenge.
Immediate Expensing. The Trump Administration proposed immediate expensing (the ability to write off 100% of the full cost in the year of acquisition) for buildings as part of the JCTA. Although the JCTA ultimately limited immediate expensing to personal property assets, the proposal, which would kill Section 1031, is still very much alive. The real estate industry (including Qualified Intermediaries) opposes immediate expensing of real property improvements on the basis that it would disrupt real estate markets, and would increase speculative building and transactional activity intended to serve investor tax strategies, not occupant needs. Conversely, Section 1031 provides the same tax-deferral, but in a non-disruptive manner that won’t lead to a bubble and burst.
How do we save Section 1031? Pre-JCTA, we successfully made the case that Section 1031 should be preserved because it stimulates the US economy, benefits taxpayers of all sizes, and creates jobs. However, that message must continue to be delivered, both to educate new Members of Congress to the benefits of Section 1031, as well as to remind all Congresspersons that Section 1031 is a poor choice of pay-for as cuts and tax reforms are sought to generate revenue for necessary and desired spending. You can help. Click here to send a letter to your U.S. Senators and Representative and let them know how important like-kind exchanges are to you and your clients.
Read 1031Sustaining American Businesses here.
Current Status of IRC Section 1031
The Tax Cut and Jobs Act (TCJA) which took effect on January 1, 2018 eliminated personal property assets, including tangible, intangible and living (e.g. breeding livestock, race horses) from IRC Section 1031 like-kind exchange treatment. Section 1031 now applies exclusively to real estate assets, and has been retitled, “Exchange of real property held for productive use or investment.”
Proposed Regulations REG-117589-18. In response to the changes made by the TCJA, the IRS published Proposed Regulations on June 11, 2020 addressing the definition of real property. The Proposed Regulations clarified that definitions of real estate that are specific to other IRC sections do not apply for Section 1031 purposes.
The Proposed Regulations define real property qualifying for like-kind exchange treatment essentially as “land and improvements to land, unsevered crops and other natural products of land, and water and air space superjacent to land.” Land improvements are further defined as “inherently permanent structures and the structural components of inherently permanent structures.” Lesser interests such as leaseholds and easements continue to qualify under Section 1031. Notable inclusions in the definition of real property are options to acquire real property and certain intangibles, including licenses and permits, that derive value and are inseparable from the real property, and contribute to the use of the subject real property, rather than production of income (except rent for use of the space). Finally, the IRS confirmed that with few exceptions, state law definitions of real property are not controlling for purposes of Section 1031.
Although the above definitions are pretty straight-forward, the IRS solicited comments related to a number of provisions in the Proposed Regulations. It is not known when final regulations will be issued.
Impact of the Tax Cut and Jobs Act on Sec. 1031
The major change to Section 1031 is the complete repeal of personal property exchanges. The Code section now refers exclusively to real estate assets, and has been retitled, “Exchange of real property held for productive use or investment.”
Real estate exchanges are subject to the same rules and regulations as under previous law. The 45 day identification and 180 day exchange periods remain unchanged, as does the role of the Qualified Intermediary. All real estate in the United States, improved or unimproved, also remains like-kind to all other domestic real estate. Foreign real estate continues to be not like-kind to real estate in the U.S.
Personal property assets that can no longer be exchanged include intangibles, such as broadband spectrums, fast-food restaurant franchise licenses and patents; aircraft, vehicles, machinery and equipment, railcars, boats, livestock, artwork and collectibles.
Immediate expensing. The full cost of tangible business use personal property assets such as heavy equipment, farm machinery, vehicles and hotel furniture can be written off in the year that they are placed in service by the taxpayer. Although tax can no longer be deferred through like-kind exchanges for these assets, the full expensing deduction can be used to offset any capital gain or depreciation recapture recognized in that same or future years. Full expensing is temporary; it will expire in 2022, and will be reduced to 80% for assets placed in service in 2023, 60% for 2024, 40% for 2025 and 20% for 2026. This deduction applies to both new and used assets acquired by the taxpayer.
Many thanks go out to all who tirelessly helped throughout this process of advocating for preservation of Section 1031 through meetings, calls, letters and more. Without all of our voices informing Congress of the broad benefits of Section 1031, this important tool could have been eliminated in its entirety. Everyone helped and every bit of help mattered. Congratulations to us all!
We are especially grateful to all of the Members of Congress that listened, understood, and supported retention of Section 1031 in this tax reform bill.
When investors or businesses structure their real estate sale and replacement purchases as §1031 Like-Kind Exchanges, they are able to defer payment of capital gains and recapture taxes. The like-kind exchange is a powerful tool that encourages people and entities to re-invest their profits into more productive property that is better suited for current and future needs, stimulating business and economic growth, and improving communities. (See What is a 1031 Exchange infographic)
In some U.S. markets, real estate brokers claim that §1031 exchanges touch at least 40% of the real estate investment transactions. Eliminating the option of structuring transactions as like-kind exchanges would not only cause a sharp drop in real estate transactions, but the additional business and services generated from the transactional activity related to §1031 exchanges would fall as well. In 2015, Ernst & Young, LLP released a macro-economic study on the impact of repealing or limiting 1031 exchanges that quantified that the US economy would actually contract if §1031 was repealed or limited. Similar microeconomic impact studies, focused on commercial real estate, by Professors David Ling and Milena Petrova, have further confirmed that if Section 1031 was eliminated or limited, transactional activity would diminish, the cost of capital would rise, the rate of investment would fall, holding periods would increase, property values would reduce, and rents would rise. (Repeal of 1031 Exchange infographic).