1031 Tax Reform Issues
Potential new legislation and rule changes to reform the tax code are in the works. Specific goals for tax reform include achieving a simpler, fairer, and flatter tax code that is more efficient and results in greater financial growth, job creation, and a strengthened economy. Tax reform may include either repeal or restriction of 1031 Exchanges.
Will a repeal of section 1031 accomplish the goals of tax reform set by Congress? NO!
- Repeal of §1031 will not accomplish the goals of tax reform
- Repeal of section 1031 will not increase fairness
- Repeal of section 1031 will tax cash flow, not wealth
- Repeal of section 1031 will not raise significant revenue
- Repeal of section 1031 will cause a decline in real estate values, a drop in manufacturing, and economic stagnation
- Section 1031 encourages reinvestment over profit taking, and it provides a strong incentive to keep that investment at home, in the United States.
Can retention of section 1031 laws help achieve goals set by Congress? YES!
The House Ways and Means Committee stated, “Every dollar small businesses spend on taxes and tax compliance is a dollar they do not have to invest in equipment, start a new production line, hire a new employee or provide more in wages and benefits.” (1) The Committee further posited, “Our outdated international tax system actually encourages American businesses to keep profits and jobs outside of America.” (2) The Committee concluded, “Simply put, if taxes were not so high…businesses would have the resources to reinvest in their businesses and help grow the economy of their communities.”(3)
The tax deferral benefit provided by section 1031 is a valuable tool for meeting all of these goals. It provides a powerful engine to the US economy. Like-kind exchanges promote transactional activity that results in jobs and taxable income that, in turn, fuels other businesses, including small and mid-sized businesses. And since foreign real estate and assets used predominantly outside of the United States cannot be exchanged for domestic real estate and assets such as machinery and equipment, the section 1031 deferral benefit directly stimulates reinvestment in US communities and businesses, promoting job growth within our own borders.
1 “The Tax Reform Act of 2014, Fixing Our Broken Tax Code So That It Works For American Families and Job Creators,” House Ways and Means Committee, p.11.
1 Ibid., p.9
1 Ibid., p.10
Is section 1031 a tax loophole? NO!
IRC section 1031 is a powerful economic engine based on sound tax policy. The non-recognition exchange policy is premised on the understanding that the taxpayer continues with the same qualifying investment, with no intervening receipt of cash, and is left in the same tax position as if the relinquished asset was never sold. This valuable section should be retained in its current form because it accurately reflects the economic reality of investment continuity in which no profit is taken, thus there is no premise to tax.
Is section 1031 an “abusive tax avoidance scheme?” NO!
Section 1031 provides only a temporary deferral; taxes are not eliminated. Tax will be paid either upon sale of the replacement asset, or incrementally, through increased income tax due to foregone depreciation, or by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
What are the risks of repealing section 1031?
- Repeal of section 1031 will cause a decline in real estate values
- Elimination of section 1031 would result in a substantial increase in depreciation deductions and reduced income tax revenue.
- Elimination of section 1031 would have a chilling effect on real estate, manufacturing and other business transactions.
- Fewer transactions also translate into fewer jobs not only in the 1031 Exchange industry, but also in the real estate, construction, title insurance, mortgage and other related industries, equipment lease financing, vehicle and heavy equipment rental and manufacturing, after-market alteration, customization and installation industries.
How would repeal of 1031 affect the cash flow of a business?
Elimination of section 1031 would tax cash flow, not wealth. Section 1031 permits a continuity of investment by the taxpayer without reducing cash flow available for growth of the business. The value of assets exchanged, whether farmland, commercial or rental residential real estate, machinery, equipment, vehicles or other business-use or investment assets, remains invested in the taxpayer’s business.
Without the current treatment under section 1031, cash-strapped owners of business-use and investment assets could be forced to downsize their businesses, farms, ranches, real estate holdings, etc. if they don’t have sufficient additional cash flow to acquire replacement assets and pay tax on the gain or depreciation recapture of the old asset.
Will longer depreciation schedules introduced by proposed depreciation pools unfairly impact taxpayers that are taxed at individual rates?
Unlike corporations, farmers, ranchers, real estate owners, and others holding assets in pass-through entities will be unfairly and negatively impacted by substantially reduced depreciation deductions coupled with individual tax rates that will be higher than the targeted 25% corporate rate. The effect of the depreciation pools is that depreciation for many assets will exceed the life of the asset. For example, farm equipment purchased at a cost of $300,000 which under current rules would be subject to 7 year MACRS, would be fully depreciated in its 8th year of ownership. That same unit of agricultural equipment, under the Pool 2 proposal, would not be fully depreciated until its 30th year of ownership, long after its useful life has ended. The combination of present MACRS depreciation rules with 1031 Exchanges provides a stronger cash flow benefit and therefore, a stronger economic stimulus to businesses. Elimination of section 1031 with a transfer to a pooling depreciation method will cause these individual taxpayers and small businesses to retain assets longer, since there is a reduced cash flow incentive to reinvest.