Lawmakers threaten to end like-kind exchange tax provisions, but some say the cost would be too great

There’s a contingent of lawmakers and government officials lobbying to alter the face of like-kind exchanges, with some hoping to outright repeal the rules governing these unique transactions. However, in recent months, two studies championing the more long-term value of like-kind exchanges have been published, both arguing that like-kind exchanges encourage investment, contribute to federal tax revenues and help create jobs, among other benefits.

Guaranteed under Section 1031 of the U.S. Code, like-kind exchanges offer individuals, investors, businesses, etc., a means to exchange “property held for productive use in trade or business or for investment (without a recognized gain or loss) 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.” In the event of a like-kind exchange, the seller/purchaser is able to defer capital gains taxes, which has proven a major point of contention.

In President Obama’s proposed FY 2016 budget, the administration outlines a small provision to 1031 exchanges, which, if approved, would limit tax deferrals for such exchanges to $1 million per year, per taxpayer.

In its explanation of the proposal, the U.S. Treasury Department wrote that there is “little justification for allowing the deferral of the capital gain on the exchange of real property….” The Treasury explained that, historically, the 1031 deferral has been justified simply because valuing exchanged property is difficult, but pointed out that in order to make a like-kind exchange the value of the properties must first be determined. Ultimately, it said that the “ability to exchange unimproved real estate for improved real estate encourages ‘permanent deferral’ by allowing taxpayers to continue the cycle of tax deferred exchanges.”

Some, like U.S. Representative Dave Camp (R-Mich., 4th), have argued the exchanges be done away with altogether.

The National Association of Realtors, which has a vested interest in the debate, is lobbying lawmakers to keep 1031 in tact, and recently released a survey illustrating what it said is the important benefits of like-kind exchanges.

Creating Jobs and Opportunity

In its survey, NAR reinforced the economic importance of real estate, calling it the “foundation of economic activity,” and suggested that like-kind exchanges play a key role in maximizing market performance.

“For a significant proportion of real estate market participants, like-kind exchanges provide an important vehicle to dispose and acquire property,” the report reads.

Compiling sales figures from both its commercial and residential membership, NAR determined that in 2014 the average fair market value of all transactions was $7 million. For each respondent, like-kind exchanges accounted for an average of 39 percent of their FMV, or $2.7 million.

Furthermore, NAR claimed the economic benefits of like-kind exchanges extend beyond the initial transaction, as they have been found to encourage investment and job creation. NAR estimates that in like-kind exchanges in which a Realtor is involved, between 10 and 35 jobs are created – most a result of needed building improvements on the property. Forty percent of NAR members, particularly investors and those working in the commercial side of the industry, went as far as to say that without the tax provisions provided under 1031, the transaction would not have occurred at all, while 56 percent admitted that even if the transaction did take place, it would likely have been on a much smaller scale.

“Like-kind exchanges that allow investors and businesses to defer capital gains taxes on the exchange of similar properties bring great advantages to investors, real estate markets and the economy,” said Lawrence Yun, NAR chief economist. “Realtors and their clients often look for better economic use of existing properties that are underutilized, which helps promote local economic development and increase the nation’s gross domestic product.”

Regardless of NAR’s data, opponents of the practice say the benefits don’t justify the federal expense.

When $10 Billion is the Cheaper Option

In a March estimation, the Joint Committee on Taxation claimed that by modifying like-kind exchange rules, the government could increase tax revenues by more than $10.5 billion from 2015 to 2025. However, in a report published by business management consulting firm Ernst & Young, researchers determined the repeal of 1031 would lead to extended holding periods, “less-productive deployment of capital in the economy” and a swollen reliance on debt financing.

“The net impact suggests that this policy change is at cross-purposes with some of the objectives of tax reform,” the report reads. “While repealing like-kind exchange rules could help fund a reduced corporate income tax rate, its repeal increases the tax cost of investing by more than a corresponding revenue neutral reduction in the corporate tax rate.”

Ernst & Young estimates that in the event 1031 is repealed, over the long-term, GDP would fall annually by $8.1 billion, investment would fall by $7 billion and labor income would slip by $1.4 billion.