Congress eyes killing 1031 capital gain exchanges

By Oregon Tax News,

There is much debate about tax reform in Congress and one idea is to eliminate 1031 capital gain exchanges. This idea would have terrible consequences.

Any American business owner will tell you that overhauling the tax code is long overdue. If you ask these same business owners what they believe is working effectively in the Code they will undoubtedly point to a lesser-known provision found in Section 1031.

IRC Section 1031 empowers businesses to defer capital gain and depreciation recapture taxes on certain assets through like-kind exchanges. Investors and business owners can exchange, in a tax-deferred manner, into similar assets that better meet current business needs. Unfortunately, some in congress see this as a treasure trove of tax increases and are working to repeal Section 1031.

Simply stated, like-kind exchanges facilitate continuity of business investments. Under present law, no gain or loss is recognized if real estate or personal property held for productive use in a trade or business or for investment is exchanged for property of a “like-kind.” For example, real estate may be exchanged for real estate, cars for cars, construction machinery for construction machinery and so on. No profit or cash is extracted, and no taxes are eliminated. Rather, taxes are deferred and paid: 1) incrementally, starting immediately after the exchange, through increased income tax due to foregone depreciation on the new asset which has the same built in gain and a lowered tax basis; 2) upon final sale of the asset; or 3) through inclusion in a deceased taxpayer’s taxable estate subject to the estate tax which is double the capital gains tax rate.

Far from a tax loophole, the like-kind exchange provision is tightly worded, strictly defined, enforced by Regulation, and consistent with other parts of the Code. For instance, Section 1031 is similar to other provisions in the Code, such as contributions of assets to partnerships or corporations. Section 1031 is arguably one of the most effective and powerful capital formation and wealth creation tools currently built into the Code. And here’s the best part: it’s fair. Section 1031 is widely used by small businesses and individuals of modest means as well as mid-sized and large corporations.

A recently released Ernst and Young macroeconomic study backs up this capital formation argument. Findings from the report demonstrate that repealing Section 1031 like-kind exchanges would reduce overall US Gross Domestic Product somewhere between $61-131 billion over ten years. Real estate and construction top the list of the ten industries disproportionately affected, with a projected reduction of $26 billion annually, representing a combined 72 percent of this burden. Additionally, should Congress repeal Section 1031, small and pass-through businesses would be subject to a higher effective tax burden on their transactions–somewhere in the ballpark of 40 to 50 percent.

While comprehensive tax reform is a worthy pursuit and lower tax rates are a tempting proposition for Congress, the opportunity cost and fallout of repealing Section 1031 would be the loss of a valuable economic driver that increases the velocity of the overall economy through increased transactional activity. There is nothing else quite like it in the Code. Tax reform should certainly lower rates, but it should also create and retain existing capital formation incentives. Businesses should be incented to reinvest and rollover their built-in capital gains in real estate to other like-kind business assets and preserve cash flow.

Congress must weigh the unintended consequences of repealing any tax provision that ends up boomeranging back and causing harm by impeding economic growth and competitiveness and blocking investment, job creation and capital formation. By preserving Section 1031, businesses are able to continually grow sales, expand employment, and drive economic growth.

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