Tax Reform / 1031 Exchange Update

Posted Jul 5, 2017

A picture of the United States Capital

Part 3 in the Realized series "2017 Tax Reform Impact on Real Estate"

Realized is carefully monitoring the discussions in Washington concerning tax reform and receives regular updates from trade group lobbyists. Among the topics discussed is the elimination of IRC §1031 “like-kind” exchanges. Legislators in favor of doing away with 1031 exchanges often cite a 2014 Joint Committee on Taxation Study that estimates this will increase Federal tax revenues by $40.6 billion over ten years.

Like-kind exchanges have been thought of by many as a “loophole” for the wealthy for decades.

Interestingly, with discussions centered on overhauling the tax code, eliminating 1031 exchanges appeared to have some support from the commercial real estate industry largely because real estate investors would receive something in return.

Specifically, while the Republican’s Blueprint For America and Trump’s tax proposal are silent on 1031 exchanges, they both call for immediate expensing of capital expenditures. Immediate expensing (aka Direct Expensing) would remove the accounting principal of depreciating capital assets over their useful lives. Instead, taxpayers could simply write-off the full value of capital investments in the year made. To the extent that these write-offs exceed taxable income, they would have a tax loss carryforward to offset taxable income in future years. Frankly, immediate expensing would be a good tradeoff for real estate investors and corporations alike. Under a direct expensing model, except for land which is not depreciable, there would not be much need for 1031 exchanges.

Given the chaos in DC, it now appears that we will get watered-down tax reform, but it will not include changes to 1031 exchanges. There is an intensive lobbying effort by the industries that rely on 1031 exchanges: real estate, transportation, oil & gas, equipment leasing, and construction. Together, these sectors represent a significant source of employment and GDP growth. These groups argue (correctly) that changing the 1031 exchange laws would: reduce capital expenditures/investment —> place downward pressure on employment —> slow the economy —> cost jobs. Not really in line with “Making America Great Again.”

Going into the midterms, a significant slowdown in the US economy would be a nightmare for the Republicans. In addition to Trump having made his fortune in real estate, many members of his cabinet have close ties to the industries that would be most affected by a repeal of IRC §1031. Specifically, Rex Tillerson is the former CEO of Exxon; Steve Mnuchin has close ties to the mortgage industry, Rick Perry is from Texas, the second largest oil & gas state, and Wilber Ross has been a longtime investor in capital intensive industries.

My bet is there’s probably a 30% chance that 1031 exchanges will be affected by any immediate tax reform. Section 1031 has been part of the tax code since 1921 and is almost as old as the Code itself.

One final comment, the 2014 Joint Committee on Taxation’s estimate of $40.6 billion in additional tax revenue over one decade is predicated on an economy that’s early in the business cycle, which we are obviously not today. Ultimately, these tax revenues will only materialize if businesses and investors are transacting at increasing asset prices that result in taxable capital gains.

Realized 1031 is scrutinizing the tax reform proposals carefully. To find out the latest on tax reform changes and how it might impact your current or future real estate holdings, contact us at 877-797-1031.

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