Republican Tax Reform Plan Puts 1031 Exchanges On The Chopping Block
In June 2016, while Americans were focused on the presidential election, a Republican task force unveiled a 35-page blueprint for tax reform. Dubbed “A Better Way,” the reform attempts to overhaul tax policy and to stimulate the economy through lower rates, reduced paperwork, job growth and tax incentives.
Among the proposed changes, an almost century-old real estate investment tool, the 1031 exchange, faces elimination.
Investors use 1031 exchanges as a way to defer the tax from any capital gains earned through the sale of a property, so long as the money is immediately used to purchase another asset. Swaps can be between various real property types, like land or multifamily buildings, or can include things like machinery, equipment or vehicles, and tax remains deferred until the property is sold with no reinvestment.
Eliminating 1031 exchanges is not a new idea. In 2014, Congress’ Joint Committee on Taxation estimated a tax-revenue gain of $40B over 10 years by repealing Section 1031. President Barack Obama later proposed a $1M cap of gain deferral under these exchanges, and suggested removing collectibles, artwork and personal property as allowable property types.
The Republican blueprint offers no direct mention of like-kind exchanges. In its place, the plan allows for investors to immediately expense new business and investment assets, including buildings, but not land. Rather than wait for the full depreciation of the property over 27.5 to 39 years, they can write off the full value after the first year.
Proponents of immediate expensing argue that investors can offset the taxes due to gain and recapture on the first property by immediately writing off the improvements on the new property, creating an indefinite tax loss that would roll forward, similar to a 1031 exchange.
Immediate expensing cannot fully replace 1031 exchanges, according to Fidelity National Title Insurance executive vice president and IPX1031 president John Wunderlich. Unlike the former, it does not take land value into consideration. This not only reduces investment opportunities for agriculture and ranching, where land value is 90% of the investment value, but also forces property owners to constantly trade up to avoid losing any of their profit to recapture and capital gains taxes.
When it comes time to sell properties close in value, the taxes would likely wipe out any profits from the appreciation in value.
Timing also comes into play. When the sale and replacement purchase bridge two tax years, investors will have to pay all of the taxes in year one — the year of the sale — and will have less money to reinvest in year two. There is no proposal for a carry back of the expensing loss obtained in year two, the year of the purchase.
Wunderlich predicts a chilling effect as a result of investors being unwilling to reinvest in other properties without the cushion of Section 1031.
“Investors will be locked into their investments because of recapture taxes,” Wunderlich said. “They will hold onto their properties longer rather than face the negative tax consequences.”
A Republican-controlled House and Senate have pushed this plan closer to fruition, but not without opposition. Over 100 real estate, agricultural and equipment associations have spoken out in favor of Section 1031. Members of the IPX1031 team, who represent Fidelity National’s tax-deferred exchange business, have met with Congressional leaders like Speaker Paul Ryan to find a better solution for the new tax policy.
“Congress is trying to reorganize the U.S. economy, and that is a tall order,” Wunderlich said. “It may be too big of an issue to deal with all at once.”
Individuals can also voice their concern. Head to the IPX1031 website to send an email to local congressmen and senators.
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