Related Topics
- Section 1031 basics
- The economic benefits of like-kind exchanges
- Section 1031, agriculture, and conservation
- The case for Section 1031 like-kind exchanges
Questions
- What is the IRC Section 1031 like-Kind Exchange provision?
- What is the role of a Qualified Intermediary?
- Who uses like-kind exchanges?
- What are the benefits of a like-kind exchange?
- How, and when, are taxes paid?
- What are the tax policies upon which Section 1031 is based?
Section 1031 and the Economy
- How do like-kind exchanges stimulate the economy?
- How can Section 1031 exchanges benefit businesses, ranchers, and farmers?
- How can like-kind exchanges be used for conservation and environmental policies?
Repeal of Section 1031
- Would repeal of Section 1031 accomplish the goals of good tax policy?
- Section 1031 like-kind exchanges have been called a loophole. Is this accurate?
- Is Section 1031 an “abusive tax avoidance scheme?” No! How so?
- What are the risks of repealing Section 1031?
- How would repeal of 1031 affect the cash flow of a business?
Responses
WHAT IS THE IRC SECTION 1031 LIKE-KIND EXCHANGE PROVISION?
Like-Kind Exchanges, also referred to as “tax-deferred exchanges” and “1031 exchanges,” are property “swaps” that allow an owner to trade out of real estate that no longer meets their needs and into better-suited property, without an up-front tax burden. Taxes, from a traditional sale and subsequent purchase, are deferred under an exchange. The exchanges allow property owners to “trade up” to larger or better rental and commercial property, consolidate farmland, and swap ranch land to achieve conservation goals. The tax deferral mechanism of like-kind exchanges helps increase the value of the property both to the economy and the owner, motivates owners to transfer property, and allows the transactions to occur. Taxes are eventually repaid—at a larger amount—in subsequent sales. Any remaining proceeds from the exchange are immediately taxed. A third-party, independent facilitator, a Qualified Intermediary (QI), is required to hold the proceeds of sale so that the taxpayer does not have receipt or control of the funds during the exchange.
Like-kind exchanges are defined by Internal Revenue Code Section 1031, established in 1921, shortly after the enactment of the federal tax code. Exchanged assets are limited to business-use and investment real property, such as commercial, agricultural, and rental real estate, and other real-property assets involved in a broad spectrum of industries. Section 1031 like-kind exchanges are one of the few incentives available to, and used by, taxpayers of all sizes.
Read more about the essential elements of Section 1031 Like-Kind Exchanges.
WHAT IS THE ROLE OF A QUALIFIED INTERMEDIARY?
Tax rules for non-simultaneous exchanges require the use of an independent third-party Qualified Intermediary (“QI”). The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any taxable, unused funds to the taxpayer at the end of the exchange. Qualified Intermediaries are not fiduciaries and, by definition, must remain independent from the taxpayer.
Read more about the role of the Qualified Intermediary.
WHO USES LIKE-KIND EXCHANGES?
Section 1031 benefits, and is widely used by, a broad spectrum of taxpayers at all levels in all lines of business, including individuals, partnerships, limited liability companies, and corporations.
Farmers, ranchers, landlords, individual investors, and conservation organizations also benefit from like-kind exchanges to transition to properties that better suit their needs, increase their investment, or achieve conservation goals. Individuals of modest means, high net worth taxpayers, small businesses, large entities, and all those in-between use Section 1031.
WHAT ARE THE BENEFITS OF LIKE-KIND EXCHANGES?
Following a like-kind exchange, the business or investor is left with more working capital and can roll that money back into the business. The economy benefits because the business owner cannot receive a tax deferral benefit without reinvesting those savings back into the business, so businesses are encouraged to expand or upgrade their properties and other assets. Since properties located or used within foreign countries are not like-kind to assets in the United States, Section 1031 promotes reinvestment and job growth within our U.S. borders.
HOW, AND WHEN, ARE TAXES PAID?
In a like-kind exchange, capital gains taxes are deferred but not eliminated. The taxpayer pays tax when the replacement property is subsequently sold, often with a taxable gain that is greater than that of the original transaction, had it been a traditional sale. Payment of tax occurs:
- upon sale of the replacement asset;
- incrementally, through increased income tax due to foregone depreciation; or
- by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
WHAT ARE THE TAX POLICIES UPON WHICH SECTION 1031 EXCHANGES ARE BASED?
Section 1031 has remained in the tax code since 1921, notwithstanding repeated Congressional scrutiny, because it is based on sound tax policy that is predicated on continuity of investment by the taxpayer. Section 1031 is consistent with goals of efficiency, neutrality, fairness, and simplicity within the tax system. Section 1031 promotes business decisions that stimulate U.S. job creation and growth of the U.S. economy. Section 1031 promotes efficient use of productive capital and operating cash flow. Section 1031 exchanges facilitated by Qualified Intermediaries are neither abusive nor administratively difficult for either the IRS or taxpayers.
Read a deeper explanation of the rationale and legislative history of Section 1031.
Section 1031 And The Economy
HOW DO SECTION 1031 LIKE-KIND EXCHANGES STIMULATE THE ECONOMY?
Section 1031 like-kind exchanges stimulate the economy, contribute to the velocity of the economy, and promote job growth within the United States through the mechanism of the deferral of the taxable gain. The transactional activity generated results in taxable income, job growth, manufacturing, financial services, construction, improved neighborhoods, and tax revenue to states and local communities. Ultimately, this economic stimulus spills over to create jobs in factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after-tax dollars of employed workers.
HOW CAN SECTION 1031 EXCHANGES BENEFIT BUSINESSES, RANCHERS, AND FARMERS?
For all businesses, Section 1031 permits efficient use of productive capital and cash flow while allowing taxpayers to shift to more productive like-kind property, change geographic locations, diversify or consolidate holdings, or otherwise transition to meet changes in business needs. Tax-deferred exchanges provide an important stimulus to economic sectors, having local and national effect. Farmers and ranchers use Section 1031 to combine acreage, acquire higher grade land, or otherwise improve the quality of their operation. Retiring farmers exchange their most valuable asset, their farm or ranch, for other real estate without diminishing the value of their life savings.
HOW CAN LIKE-KIND EXCHANGES BE USED FOR CONSERVATION AND ENVIRONMENTAL POLICIES?
Grants of conservation easements can be structured as tax deferred exchanges, facilitating government and privately funded programs designed to improve water quality, reduce soil erosion, maintain wetlands, and sustain critical wildlife habitat. These exchanges enable landowners to acquire replacement farm or ranchland in less environmentally sensitive locations.
Repeal Of Section 1031
WOULD REPEAL OF SECTION 1031 ACCOMPLISH THE GOALS OF GOOD TAX POLICY?
No, repeal of Section 1031 is counterproductive to the goals of good tax policy.
- Repeal of Section 1031 will not Increase economic fairness.
- Repeal of Section 1031 will tax cash flow, not wealth.
- Repeal of Section 1031 will not raise significant revenue.
- Repeal of Section 1031 will cause a decline in real estate values, and create economic stagnation.
- Section 1031 encourages reinvestment over profit taking, and it provides a strong incentive to keep that investment at home, in the United States.
SECTION 1031 LIKE-KIND EXCHANGES HAVE BEEN CALLED A LOOPHOLE. IS THIS ACCURATE?
IRC Section 1031 is an intentional, powerful, economic engine based on sound tax policy—not a loophole. The non-recognition exchange policy is premised on the understanding that the taxpayer continues with the same qualifying investment, with no intervening receipt of cash, and is left in the same tax position as if the relinquished asset was never sold.
Tax will be paid:
- upon sale of the replacement asset; or
- incrementally, through increased income tax due to foregone depreciation; or
- by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.
This valuable section should be retained in its current form because it accurately reflects the economic reality of investment continuity in which no profit is taken, thus there is no premise to tax. A well-understood body of Treasury Regulations and other guidance prevent abuse.
IS SECTION 1031 AN “ABUSIVE TAX AVOIDANCE SCHEME?”
IRC Section 1031 provides only a temporary deferral; the tax is not eliminated.
WHAT ARE THE RISKS OF REPEALING SECTION 1031?
- Repeal of Section 1031 would cause a decline in real estate values.
- Elimination of Section 1031 would result in a substantial increase in depreciation deductions and reduced income tax revenue.
- Elimination of Section 1031 would have a chilling effect on real estate and business transactions.
- Fewer transactions also translate into fewer jobs, not only in the Section 1031 exchange industry, but also in the real estate, construction, title insurance, mortgage, and other industries.
HOW WOULD REPEAL OF 1031 AFFECT THE CASH FLOW OF A BUSINESS?
Elimination of Section 1031 would tax cash flow, not wealth. Section 1031 permits a continuity of investment by the taxpayer without reducing cash flow available for the growth of the business. The value of assets exchanged, whether farmland, commercial or rental residential real estate, or other business-use or investment asset, remains invested in the taxpayer’s business. Without the current treatment under Section 1031, cash-strapped owners of business-use and investment real estate could be forced to downsize their businesses, farms, ranches, and real estate holdings if they don’t have sufficient additional cash flow to acquire replacement assets and pay tax on the gain or depreciation recapture of the old property.
