Browse Tag: Internal Revenue Code section 1031

Impact of Tax Code Reform on 1031 Exchanges

Today’s guest post is by Wayne D’Amico, CCIM, EVP of Corporate Development & Strategic Relations with Xceligent & Past President and Chairman of the CCIM Institute. Since 1987, D’Amico has been engaged in diversified services in nearly a billion dollars of commercial and investment real estate projects in the areas of strategic and valuation consulting, transactional brokerage and creative financing to a national clientele.

 

Stumping for the preservation of Internal Revenue Code Section 1031, Like Kind Exchange rule, appears to be another attempt by rich folk looking to keep their trough over flowing at the expense of the little guy.  Will the promised Trump tax reform preserve 1031 rules or gut them to the chagrin of investors?  It’s complicated, but let’s try to break it down.

 

The Tax Code provides that the seller of real estate does not pay tax on any increase in value (gain) at the time of sale – provided, the seller invests all the sale proceeds into another property.  The tax is not avoided, but deferred until the time that the owner sells and cashes out instead of buying another property.

 

Why was Section 1031 enacted nearly 100 years ago?  Unlike buying and selling stocks, real estate transaction volume, velocity and value stimulates economic activity.  How?  Every real estate deal results in more work for a variety of jobs including appraisers, brokers, consultants, engineers, lenders, inspectors, insurers and contractors.  Greater transaction volume requires more people to perform the ancillary jobs.  And as real estate values increase, more money goes to those jobs.   The rule incentivizes owners to reinvest sale proceeds into the next deal within 180 days generating tremendous velocity in the market.  If you believe in this argument that robust real estate transaction environments are drivers of the overall economy, then legislation that supports higher sales volume and velocity ensure favorable economic stimulus.  Need stats?  In 2014, the National Association of REALTORS study suggests that some 39% of transaction volume was associated with 1031 related deals.  Eliminating the 1031 code will reduce the overall capital available to buy future properties by 25 to 40 percent due to capital gains tax and reduce the velocity with the removal of the 180-day reinvestment requirement.  If the capital pool controlled by private investors is reduced, the economy will slow and shrink.

 

Can revision of this code be a good idea?  Sure.  The real estate investor is not a species that is inherently averse to taxation.  In fact, it’s really just math.  The decision to utilize the 1031 rule is not about an aversion to taxes empirically. It is the impact of the tax expense within a financial analysis of the return to the investor on and of her money invested in the real estate as it performs over time that matters.  The amount and timing of the tax are simply variables that plug into the proforma along with many more factors that result in an overall investment return.  If the right set of comprehensive tax reforms were put together as a part of the repeal of 1031 considering amongst other things depreciation, capital gain rates, real estate tax policies, overall economic conditions and interest rates to name a few, I can envision a world without 1031.  But, until I see such a proposal in detail, I’d rather keep the 1031 rule in place and let the private sector do the heavy lifting of stimulating the economy.

Politician Cites 1031 Exchanges As…Divine Financial Advisory?

US Capitol Building

Ah, the political season.  The time when persons with sometimes monumentally odd ideas about cause and effect stand on a stump and broadcast these ideas loudly and clearly.

Well, loudly, anyway.

Meet Ben Carson.  A retired surgeon from Detroit, Carson’s political star is rising thanks to a strong showing in a recent straw poll. Riding the wave of recent notoriety brought him to a radio appearance, where an interviewer asked, in the context of Carson’s self-declared religious faith, if he had ever been “angry with God”.

Incredibly, his answer somehow included one of the real estate industry’s most venerable tax deferments and a favorite topic here at The Source: the IRS 1031 exchange.

The only other question I was given time to pose came […] when I asked Carson, who self-identifies as deeply religious, if he’s ever doubted or been angry with God.

Yes, indeed, he indicated, recounting an incident in which the Lord apparently subjected him to Job-like tortures over a problem involving residential real estate. After buying a new house, he just couldn’t unload the old one. “My house was on the market for five years. And I said, ‘I pay my tithes. I am faithful. I try to help people. So why is this happening to me?’ ” Carson told me.

“And [then] I found out about the ‘1031 Exchange’ [named for a tax code provision] where if you sell a piece of property and you make a very, very large profit on it, you don’t have to pay huge taxes on it if you can roll it over into another property of higher value.”

Carson’s story went on in this disjointed fashion, and didn’t seem particularly illuminating, except to suggest that it definitely wasn’t an ordinary crisis of faith and the Almighty must be a savvy adviser on the Internal Revenue Code.

So Where Did 1031 Exchanges Come From?

While it’s far from clear if Carson believes 1031 exchanges to be the work of a higher power than Congress, his answer provides food for thought. Given that I’ve written about 1031 so many times, I thought I might contribute some clarity on the point.

1031 exchanges first appeared as part of the Revenue Act of 1921, passed as a package of federal tax reductions by a Republican-majority Congress on November 23 of that year. Lauded by Treasury Secretary Andrew Mellon, the Act repealed a tax on wartime excess profits, reduced the top marginal rate on individuals from 73 to 58 percent and instituted a new and more easily avoided corporate tax.

Specifically for Dr. Carson’s benefit: everything Congress votes on is in the public record.  And a quick look at that 1921 Senate vote (found here) lists many luminaries, including  future President William McKinley (voted aye), Wisconsin firebrand Bob LaFollette (nay), and Delaware’s quasi-aristocratic Thomas du Pont (no vote).

The almighty, however, is not listed in the roll call.

(Photo credit: ttarasiuk)