Leading up to the release of the House Ways and Means Committee’s tax reform bill, called the Tax Cut and Jobs act, very little was known about which provisions were to be affected. While it would not have taken an astute commentator to posit the bill was going to reduce corporate tax rates, the method by which the House was planning to offset these cuts was another story. Nothing was safe, and some speculated that even 401(k) contributions were on the table. ((See Patricia Cohen, Limit on 401(k) Savings? It’s About Paying for Tax Cut, N.Y. Times (Oct. 28, 2017), https://www.nytimes.com/2017/10/28/business/401k-limit-tax-cuts.html.))
While our 401(k)s are safe, the section regarding like-kind exchanges of real property has been changed. ((Tax Cut and Jobs Act, H.R. 1, 115th Cong. § 3303 (2017).)) Under the bill, the tax deferral given to like-kind exchanges will now be limited to exchanges of real property, completely eliminating tax deferrals for personal property. ((Id.)) According to the Joint Committee on Taxation, eliminating these exchanges will increase revenues by about $30.5 billion over the next 10 years. ((House Committee on Ways and Means, Tax Cut and Jobs Act Section-by-Section Summary, 36 (2017), available at https://waysandmeansforms.house.gov/uploadedfiles/tax_cuts_and_jobs_act_section_by_section_hr1.pdf.))
This matters because, for the smart real estate investor, the § 1031 exchange is an incredibly effective tool for building wealth. A brief explanation on like-kind exchanges and how they work is required. The previous version of Internal Revenue Code § 1031(a) read: “No gain or loss shall be recognized on the exchange of property held for productive use in a trade or business or for investment if such property is exchanged solely for property of like kind which is to be held either for productive use in a trade or business or for investment.” ((26 U.S.C. § 1031 (2012).))
What this effectively means is that while normally an exchange between two parties is treated as sale of property, and therefore is subject to tax upon any gain, in a like-kind exchange, neither party will recognize any gain and any tax they would normally incur will instead be deferred. To illustrate, say Investor A has an investment property with a fair market value of $450,000 and a tax basis of $200,000, while Investor B has an investment property with a fair market value of $450,000 and with a tax basis of $600,000. ((Stefan Tucker, Planning with Nontaxable Realty Exchanges and Conversions, 10 Cumb. L. Rev. 709, 710 (1980).)) If they exchange their properties with each other, neither of them will recognize a gain or a loss on the transaction, despite the fact that, economically, A has realized a gain of $250,000 and B has realized a loss of $150,000. ((Id.)) Gains will only be recognized upon future disposal of the property, whereupon taxes will be incurred.
It is not surprising that the like-kind exchange has been eliminated for personal property, given that personal and real property were already treated differently by the IRS. For personal property, the definition of “like-kind” is very narrow, as the exchanged properties must essentially be identical, for example, a desktop computer for another desktop computer. Gold cannot be traded for silver, and a farm tractor cannot be traded for a truck used on the farm. However, for real property, the IRS has said that any transfer of real property qualifies as a like-kind exchange. ((Id. at 715.)) A farm in Iowa can be traded for an apartment in Manhattan, and, so long as they are equal in value, qualify for the tax-deferred treatment of a like-kind exchange.
Given this broad definition of “like-kind” for real property, it should not be surprising that this particular provision of the code is very popular among real estate investors as a way to build up their investment portfolios without ever having to pay taxes on the capital gains.
Furthermore these trades do not have to be a one-to-one transaction; with the right amount of planning, like-kind exchanges provide a great path to wealth-building. ((See Steve Frank, Avoiding Capital Gains Tax on Real Estate through the Power of a 1031 Exchange, 81 Bench & Bar 38, 39 (Jan./Feb. 2017).)). Currently, up to three properties can be exchanged for one property, so if investor A owns three properties worth $200,000, $300,000 and $500,000, respectively, using a like-kind exchange, she can exchange these properties for one with a value of $1 million.
In this case, A’s basis in the new property would be the basis of the three contributed properties combined. This provision of the code allows her to build up a portfolio with smaller deals, where she can more easily access funds, and turn that into access to finding better deals that have greater value appreciation and higher cash flows for other investments.
Were this type of exchange not available, the investor would first have to sell each of the three properties, paying taxes on the gains from each sale, and this would require her to come up with extra funds to buy the property. Or, even more likely, she would decide to keep the properties as they are, which would not provide her as much future income or appreciated value than would the million-dollar property.
By saving like-kind exchanges for real estate in the bill, Congress is preserving an incredible path for people who take risks when it comes to property ownership and development. While critics of this type of tax deferment might call it a “tax loophole,” like-kind exchanges indisputably provide an incredible economic incentive for investment in real estate.
Foreign investment in the U.S. real estate market is massive, to say the least. In fact, the amount of investment in real estate amounts to an average of $5.4 billion annually in foreign investment over the past ten years. ((Bendix Anderson, Foreign Investors Buy More Apartment Properties, National Real Estate Investor (July 26, 2016), http://www.nreionline.com/multifamily/foreign-investors-buy-more-apartment-properties.)) A substantial portion of the tax bill is intended to bring back capital that has gone overseas due to lower corporate tax rates. Saving the like-kind exchange for real estate actually helps meet this goal, as elimination of the § 1031 would likely make the market less enticing for investors who would then look for other avenues.
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