Presidential hopeful Joe Biden has proposed a dramatic revision of the tax code. While the details are unknown, the big picture is to roll back President Trump’s centerpiece legislation, the Tax Cuts and Jobs Act of 2017, and make the tax code much more progressive.
Biden’s plan, called “The Biden Plan for Mobilizing American Talent and Heart to Create a 21st Century Caregiving and Education Workforce,” does not mention Section 1031 or like-kind exchanges by name. The Biden Plan will cost $775 billion over 10 years, with the repeal of Section 1031 as a “pay for” to help cover the cost. The plan will be paid for by rolling back unproductive and unequal tax breaks for real estate investors with incomes over $400,000 and taking steps to increase tax compliance for high-income earners.
That is it; that is all we have in writing. Mr. Biden’s staff have specifically referred to Section 1031 as a pay for – clearly, Section 1031 is in the direct line of fire.
Context is Important. The context is critically important – we live in a divided country. Perhaps at no time in our history since the Civil War have the two parties been more divided on everything. The Merrick Garland/Brett Kavanaugh/Amy Coney Barrett Supreme Court debacle has further divided the nation.
Class warfare is an ugly phrase but there is a sense that repealing Section 1031 would be a form of payback; an intentional slap in the face of the current President who made his fortune in real estate. And there is an ugly little secret – the most expensive coastal regions, led by California, are the largest markets for 1031 exchanges, with billions of exchange dollars flowing away from largely Democratic states to more moderate politically and less costly Southeast, Florida and Texas markets. Repealing Section 1031 would have the secondary effect of making it much more difficult for those dollars to flow from Democratic strong-holds to less expensive and more opportunistic real estate markets.
One hopes that the tax writing committees and staff will take a more dispassionate approach, and provide a modicum of fairness to taxpayers with transition rules, but elections have consequences.
The Democratic hopefuls need billions of dollars for new programs at a time when the economy is exceptionally weak from the COVID pandemic. And the national deficit is soaring to record levels from the last COVID relief bill and deficit spending.
Section 1031 is the backbone of the nation’s real estate economy. Should Section 1031 be retained since approximately 23% of all commercial real estate transactions are the result of an exchange?
The Biden Plan was promulgated before COVID. Does the current weak state of the economy suggest a re-think would be in order if Mr. Biden is elected?
Intro to Section 1031. Section 1031 permits the deferral of gain or loss on the sale or exchange of investment or business real estate. Prior to the Tax Cuts & Jobs Act, real and personal property qualified for nonrecognition of gain under Section 1031; only real property currently qualifies for 1031 treatment.
History of Section 1031. The predecessor to Section 1031 was adopted in 1921. What was the rationale for nonrecognition of gain in an exchange?
Continuity of investment is the primary rationale. This was true when the predecessor to Section 1031 was first adopted back in 1921 and, also, in 1923, when the statute was amended to exclude stocks, bonds, notes and other securities.
Congress did not want to impose a tax on theoretical gains (so-called unrealized gains), where the taxpayer continued an investment in like kind property. Unrealized asset appreciation has never been taxed. In adopting the predecessor to Section 1031, Congress concluded that the taxpayer’s position was essentially the same after the exchange (no cashing-out): the taxpayer started with like-kind property, ended with like-kind property, and never received any cash or boot (non like-kind property). Since the taxpayer did not cash out (did not receive cash with which to pay a tax), the gain should be deferred until the property is sold in a taxable transaction.
A second rationale – recognition of the administrative burden required to detect and evaluate the large number of barters and other trades consummated each year. Keep in mind that the U.S. was a rural society 100 years ago, and there were no computers to track the large volume of barters and “horse trades.”
Section 1031 is unique – it has survived all prior revisions to the tax law. With just a few technical changes over the decades, Section 1031 remains intact in substantially the same form.
Section 1031 is not a “Loophole.” In the political discourse, provisions such as Section 1031 are commonly referred to as “loopholes.” This is not accurate.
The general rule in the tax code is gain recognition on the sale or exchange of property. Section 1031 is an express legislative exception, not a loophole.
Section 1031 provides an exception from the general rule requiring the current recognition of gain or loss realized upon the sale or exchange of property – no gain or loss is recognized if real property held for productive use in a trade or business or for investment is exchanged solely for real property of a like kind to be held either for productive use in a trade or business or for investment.
Section 1031 provides an exception only from current recognition of gain realized. The realized gain is deferred until the replacement property is disposed of in a subsequent taxable transaction.
Exchanges have become so common – some say approximately 23% of all commercial real estate transactions are exchanges – that it is easy to gloss over the strict statutory requirements and regulatory gloss that frames Section 1031. To qualify for nonrecognition, many strict statutory requirements set forth in Section 1031 must be satisfied. And a number of other substantive rules also must be satisfied. For example, Treasury Regulations provide that exceptions from the general rule of gain recognition, such as Section 1031, must be strictly construed and do not extend beyond the words or the underlying purposes of the exception. This means that, even though a transaction may satisfy the technical requirements of Section 1031, the substance of a transaction will control over its form. See Treas. Reg. Section 1.1002-1(b) and (c). If the substance of a transaction is bad, the exchange may not qualify for non-recognition.
The Internal Revenue Service and U.S. Department of the Treasury have promulgated a vast array of Regulations to assist taxpayers in complying with the statute, thereby providing, among others, rules called “safe harbors” for qualified intermediaries and reverse exchanges and clear rules permitting the qualification of Delaware statutory trust (DST) interests for 1031 treatment. Many of the regulations are formalistic, but strict compliance is required.
The term “loophole” connotes a bad motive, such as avoidance of taxation in a manner that is not consistent with legislative intent. However, the predecessor to Section 1031 has been a part of the tax code since 1921; Section 1031 reflects clear legislative intent. A run-of-the-mill exchange does not reflect a bad motive, just use of an exception to the general rule of gain recognition. This is not tax “avoidance;” this is “tax planning” within both the spirit and the intent of Congress.
For over 30 years, the IRS and Treasury have supported Section 1031 with a large number of private letter rulings, published rulings (for example, qualification of Delaware statutory trusts for 1031 treatment), and regulations. The IRS and Treasury have carried out the clear congressional intent to a surprisingly broad extent with numerous “safe harbors,” regulations and rulings. Add to that an extensive and generally supportive body of case law, including the famous Starker decision that first approved delayed or deferred exchanges, and you have a broad body of statutory, regulatory and judicial authority.
This strong body of administrative and judicial support further confirms that 1031 is not a “loophole” and exchangers are not “avoiding” tax but structuring a legitimate transaction that is a Congressionally mandated (1031 is mandatory for gains or losses) and within the spirit and intent of Congress.
What is in play in November? Everything for taxpayers making more than $400,000:
- Increase the top tax rate from 37% to 39.6% (plus 3.8% surtax on net investment income) with a lower income threshold for the top rate.
- Eliminate the 20% pass-through deduction for anyone earning over $400,000.
- Cap the value of itemized deductions.
- Increase capital gains rates to ordinary income rates above $1 million.
- Return to pre-Tax Cuts & Jobs Act estate tax rules.
- Eliminate step up in basis on death (ending the 1031 “swap till you drop” strategy).
- Limit 1031 exchanges. But the $400,000 floor could be repealed – Section 1031 could be repealed instead of limited.
Tax Cuts & Jobs Act. In 2017, President Trump oversaw one of the most extensive revisions to the Internal Revenue Code in U.S. history under a Republican-controlled House and Senate. Even then, it was not easy and took nearly a year to accomplish.