Like-Kind Exchanges on the Tax Reform Chopping Block
By: Aquiles Suarez, vice president of government affairs, NAIOP
Prior to the 2014 elections, key members of Congress critical to advancing comprehensive tax reform put forth several proposals that raised concerns for the commercial real estate industry. One of these was the elimination of what are known as “like-kind” exchanges under the current Section 1031 of the tax code. Most observers believed that these tax reform discussions were unlikely to lead to far-reaching legislation making it to the president’s desk during a contested midterm election where the Senate could change parties, and where the incentive for Republicans was to wait until that outcome was determined. But these proposals have made it clear that, in discussions going forward, we can expect Section 1031 to start off on the tax reform chopping block.
When capital assets are sold or exchanged, a taxpayer usually recognizes a capital gain or loss on the transaction. Section 1031 allows a taxpayer to defer tax on a transaction if the business or investment property is exchanged for a like-kind property. The provision is nearly 100 years old, and historically was justified because of the difficulty of valuation of some properties in highly illiquid markets. In terms of the commercial real estate sector, the Section 1031 market was relatively limited before the IRS issued “safe harbor” regulations in the early 1990s, giving participants detailed guidelines on conducting the transactions. Since then, Section 1031 like-kind exchanges have become an important part of the commercial real estate industry and represent a large amount of activity in some markets.
Those who advocate repealing Section 1031 call the provision an unnecessary loophole that, if eliminated, would provide added revenue to facilitate reform of the tax code. According to the latest estimate by the Joint Committee on Taxation (JCT), which provides revenue scores for the congressional tax-writing committees, repeal of like-kind exchanges would increase federal revenues by more than $40 billion over 10 years. Thus the provision is a tempting target for both Republicans and Democrats determined to simplify the tax code and lower overall tax rates while finding a way to pay for those changes.
In the commercial real estate industry, the ability to defer gain on like-kind exchanges facilitates well-functioning, efficient and dynamic real estate markets. Elimination of Section 1031 would, in fact, reduce the incentive to acquire, develop and improve real property, with immediate impacts on the broader economy that are not captured by the congressional revenue scorekeepers. The ability to exchange like-kind properties and defer taxes is particularly important in this industry, where assets are capital intensive and long lived, and where past depreciation deductions would greatly increase the tax burden of transferring ownership to another party. Without Section 1031, this tax-driven “lock-up effect” would result in a substantial reduction in commercial real estate activity.
In the last Congress, House Ways and Means Committee Chairman Dave Camp, R-Mich., put forth a tax reform “discussion draft” that would have eliminated Section 1031 like-kind exchanges. The Senate Finance Committee, then led by Chairman Max Baucus, D-Mont., also put forth a proposal to eliminate Section 1031. And President Obama’s 2015 Budget, released in March 2014, included language limiting Section 1031 like-kind exchanges.
The next Congress will have a different chairman of the House Ways and Means Committee, since Dave Camp did not run for re-election. That chairman most probably will be Rep. Paul Ryan, R-Wis., who has made clear his desire to continue the push for comprehensive tax reform. In the final two years of President Obama’s administration, the administration would like to add some significant legislative accomplishments to his legacy. And both Republicans and Democrats have made lowering corporate tax rates, which have harmed the nation’s international competitiveness, a stated policy goal. This combination of factors may afford both parties an avenue to push forward with major tax changes over the next two years.
While Ryan has not articulated a position on Section 1031, NAIOP and its real estate allies understand the challenges that lie ahead for commercial real estate. We have been engaged with members of Congress and their staff to help them appreciate the important function that like-kind exchanges perform in facilitating transactions within commercial real estate markets, and the negative economic effects that their elimination would have. In 2015, as initial tax reform plans are redrawn and proposed in Congress, it will be imperative that all those affected by the potential loss of Section 1031 make their voices heard by their elected representatives. For NAIOP, ensuring that the commercial real estate industry will continue to be able to use tax-deferred like-kind exchanges in the future will be a major focus of our advocacy efforts in 2015.