Keeping Property Exchanges Out Of The Crosshairs
Written by Max Hansen
Imagine a six-point bull elk crashing through a thick stand of lodge-pole pine, a dove darting from a mesquite thicket, or attempting to cast into a riffle in the face of a mountain breeze. They’re all moving targets you may have faced at times, so you can understand the quandary of Realtors, tax advisors, and property owners everywhere faced with the prospects of comprehensive tax reform in 2017. The House of Representative’s tax reform “Blueprint” is the ultimate moving target, especially when it comes to the impact it will have on like-kind exchanges of property.
Since 1921, Federal tax law under Internal Revenue Code §1031 has permitted taxpayers to exchange business-use or investment assets for other like-kind business-use or investment assets and defer the taxable gain on the transaction. Qualifying assets include commercial buildings, agricultural and rental real estate, aircraft, trucks, automobiles, trailers, containers, railcars, equipment of all kinds, livestock, and other assets involved in a broad spectrum of industries.
In the intervening years, like-kind exchanges have become a powerful driver of economic growth. The provision has survived for almost a century in spite of major tax reform measures. It is a tax deferral mechanism, and taxpayers do not avoid ultimately paying capital gains tax if they cash out of their property. Secondly, like-kind exchanges are used by a broad spectrum of taxpayers ranging from individuals of modest means and small businesses to large business entities. Third, farmers, ranchers, and Main Street businesses all over the country use like-kind exchanges resulting in a ripple effect in the manufacturing sector and service industries. If the primary purpose of comprehensive tax reform is to spur economic growth, then it does not make sense to eliminate a proven tool like property exchanges.
We saw similar proposals in 2015 from both the House and Senate when the repeal of Section 1031 tax-deferred exchanges was included as a revenue raiser to lower the corporate tax rate. A Joint Committee on Taxation revenue score of $41 Billion in 10 years from repeal of Section 1031 prompted the Federation of Exchange Accommodators (FEA), National Association of Realtors, REALTORS Land Institute, CCIM Institute, National Farm Bureau Federation, Land Trust Alliance, Americans for Tax Reform and about 100 others within a like-minded coalition to commission two studies that address the myth of a revenue gain. The resulting studies prove that the elimination of property exchanges will contract the U.S. economy by $8.1 Billion or more annually, far outweighing any projected revenue gain. A more recent Tax Foundation study states that the GDP shrinkage is closer to $18 Billion annually and would result in the loss of 23,000 full-time equivalent jobs over ten years.
When June 2016 dawned with the release of the House Republican Blueprint, and there was no mention of repeal of like-kind exchanges, everyone initially breathed a sigh of relief. That sense of well-being soon evaporated when House Ways and Means Committee Chairman Kevin Brady (R-Texas) made it clear that Section 1031 would not be needed because the immediate expensing proposal within the Blueprint negated it.
What Chairman Brady and a core group within the Ways and Means Committee either don’t understand or more likely ignore in favor of reducing tax rates for corporations and other entities is that immediate expensing does not provide any benefit to certain real property owners. Farmers and ranchers know that agricultural properties are typically 80% to 100% non-depreciable land. Similarly, owners of commercial property know that at least 30% of their investment is non-depreciable land, and in many areas of the country, that percentage is closer to 50% or even more.
A taxpayer replacing low-basis commercial or agricultural real estate will typically recognize substantial capital gains that are not fully offset by the proposed expensing deduction for improvements on equal-value replacement real estate if the improvements are minimal in value or non-existent. This is the case with agricultural land or properties located in areas with high land-to-improvement value ratios. Without additional cash to cover both the tax liability and the new investment, loss of property exchanges will result in a government-induced shrinkage of agricultural and commercial real estate investments, retarding the ability for growth and diminishing the net worth of farmers, ranchers, and other real estate investors.
In addition to the shrinkage referenced above, property owners and their advisors have always been aware of the “lock-in effect.” This comes into play when property owners are faced with capital gains tax when they sell and reinvest in other real estate. Even with lower rates promised in tax reform, the value of their investments and life savings in property is reduced by the tax bill, and they are more likely to hold onto their properties longer. Deferring the gain recognition in an exchange removes the lock-in effect, takes the government out of the decision-making process, and permits taxpayers to engage in opportunistic transactions that make good business and investment sense without fear of negative tax ramifications.
Other issues come into play if current tax reform efforts eliminate property exchanges. The FEA and others have argued that farmers and ranchers use exchanges to preserve the value of their investments and agricultural businesses while they combine acreage, acquire higher-grade land, or otherwise improve the quality of their operations. They rely on exchanges to defer depreciation recapture tax when they trade up to more efficient farm machinery and equipment. Farmers and ranchers trade dairy cows for herd rejuvenation and breeding stock when they move their operations to new locations. There is no impetus for farmers and ranchers to undertake sales of their properties if tax deferral through exchanging is no longer available.
Another issue arising with the proposed repeal of like-kind exchanges is the impact on conservation easements. Like-kind exchanges make the economics work for conservation easement grants of environmentally sensitive lands that benefit our environment, improve water quality, mitigate erosion, preserve wildlife habitat, and create recreational green spaces for Americans. Farmers, ranchers, and other landowners reinvest sale proceeds from conservation conveyances through like-kind exchanges into more productive, less environmentally sensitive land. These socially beneficial conveyances are dependent upon the absence of negative tax consequences.
For all these reasons and others, proponents of the retention of property exchanges have recently and repeatedly encouraged Congress and the Administration to leave §1031 alone in the effort to revamp the Tax Code. Like-kind exchanges remove friction from business transactions and stimulate economic activity. Section 1031 facilitates the opportunistic investment of capital and community improvement. Like-kind exchanges assist in the recycling of real estate and other capital to its highest and best use in the marketplace, creating value and improving economic conditions for local communities. Landowners and other businesses will be disadvantaged if they no longer have the option of tax-deferred like-kind exchanges.
Most recently, Congress has gotten bogged down in the repeal of Obamacare and the passage of new healthcare legislation. Congress is also faced now with action on the debt limit. However, tax reform legislation and the threat against like-kind exchanges are still lurking. Please do your part to keep property exchanges out of the crosshairs by contacting your Congressional delegation. You can also obtain more information on this subject by clicking here.
About the author: Max A. Hansen is President and CEO of American Equity Exchange, Inc., an attorney, and a Certified Exchange Specialist™. He is a member of the Committee on Sales, Exchanges, and Basis of the ABA Section of Taxation and a Board member, Past President, and co-chair of the Government Affairs Committee of the Federation of Exchange Accommodators (FEA). He has conducted seminars and appeared on panels of experts around the country on the subject of Section 1031 exchanges. Some of the foregoing content is the collaborative work product of the FEA Government Affairs Committee.
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