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   ARTICLE   |   From Scotsman Guide Commercial Edition   |   November 2015

Like-Kind Property Exchanges Remain a Tax Target

But research shows the transactions actually boost long-term tax revenue

For more than three years, Republicans and Democrats in the nation’s capital have proposed an overhaul of a section of the U.S. tax code that allows investors to defer capital gains on the sale of some property. The tax-deferral policy — known as Section 1031 like-kind exchanges — survives, but remains a target of members of Congress and the White House.

Section 1031 allows taxpayers to defer gains from the sale of an investment property if the sale is followed in quick succession by the purchase of a like-kind property of same or greater value.

A study released this past June found that like-kind exchanges account for a significant portion of the commercial real estate market. Nationwide,  6 percent of all commercial real estate transactions are like-kind exchanges. In high-tax states, the figure rises to as much as 18 percent, according to “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” the study commissioned by BOMA International and the 15 other  industry groups that comprise the Real Estate Like-Kind Exchange Coalition.

Repeal efforts

As they have become more prevalent, the Section 1031 provisions of the Internal Revenue Service Code also have become a target of those in Washington looking for ways to increase federal revenue or offset tax reductions. In 2013, then-Senate Finance Committee Chairman Max Baucus, D-Mont., released a discussion draft outlining his proposals to reform the tax code, which included the repeal of the deferred gain for like-kind exchanges.

In 2014, President Barack Obama’s fiscal 2015 budget recommended limiting the capital gains deferred through like-kind exchanges for individuals to  $1 million per year. From the other side of the aisle, the outgoing chairman of the House Ways and Means Committee, Rep. David Camp, R-Mich., in 2014 released his own massive discussion draft for comprehensive tax reform. It also included a call for repealing Section 1031.

No major tax legislation is expected to be enacted leading up to the 2016 presidential election, so like-kind exchanges may have at least a temporary reprieve. But tax policymakers say the repeal of  Section 1031, and limits to it, will be on the table again in 2017. In the meantime, the mortgage and real estate industries are working to show members of Congress that the tax policy is a powerful investment tool and an important element of a healthy commercial real estate market.

Tax revenues increase

Like-kind transactions may defer taxes, but they do not eliminate them. In fact, the tax policy creates an incentive for individuals to make investments in physical business assets, and those investments provide a significant boost to the economy.

Definition

Like-kind exchange

A provision created by Section 1031 of the Internal Revenue Service code, which allows sellers to post-pone paying a tax on the proceeds of a property sale, if the proceeds of the sale are reinvested in similar property as part of a qualifying like-kind exchange.

Source: Internal Revenue Service

 

This position is borne out by the recent study  conducted by Milena Petrova, finance professor at Syracuse University; and David Ling, finance professor at the University of Florida. The findings of the study, which analyzed more than 1.6 million real estate  transactions from 1997 to 2014, rebut two main  arguments opponents have used against 1031  exchanges — that they are costly to taxpayers and are a tax-avoidance strategy.

According to the professors’ report, in 34 percent of the like-kind transactions studied, some federal tax was paid in the year of the exchange. In 88 percent of the transactions, the study said, exchanged property was eventually sold in a conventional, taxable sale, and tax revenues were 19 percent higher than they would have been if they were collected at the time of the exchange.

In addition, the study revealed that participants in like-kind transactions acquired more valuable property with less debt than they would have through conventional sales. They also sold their properties more quickly, contributing to overall real estate sales  activity, the study said.

The research data also illustrates just how detrimental eliminating Section 1031 from the tax code would be to the commercial real estate market and the economy at large. Property values would drop, rents would increase and overall real estate activity would decline if the provision were repealed, the researchers contend. The Petrova and Ling study estimated that property prices would fall 8 percent to 12 percent to maintain required equity returns for investors who had expected to use a like-kind exchange to sell properties, and rents would need to increase if new construction were to remain economically viable.

Similar studies also support the tax policy, including a 2013 industry-sponsored report from Ernst & Young, which estimates that a repeal of all types of 1031 exchanges could shrink the U.S. gross domestic product by as much as $8 billion.

•  •  •

Encouraging 1031 exchanges, instead of limiting or repealing them, is vital to sustaining the economic  recovery and strength of the commercial real estate market. Making sure that Congress understands just how important like-kind exchanges are to the economy is essential in the coming year. 


 
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