The Debate to Preserve or Eliminate Section 1031

Real Estate Exchange Property 1031 Section Tax Deferred

Real Estate 1031 Exchange

As lawmakers of the federal government struggle to deal with our ever-increasing national debt, Section 1031 of the Internal Revenue Code has come under scrutiny and may face extinction. Now that Republicans control both sides of the Congress (and the White House), Section 1031 could be seriously threatened if GOP lawmakers feel that reducing or eliminating the advantages of 1031 would prove financially beneficial for the nation as a whole. Discussions have surfaced previously about eliminating Section 1031, but current discussions appear to be more serious given the dire financial situation in which the country is encased.

Not all legislators view Section 1031 as a target for elimination; some lawmakers concur with many real estate professionals that 1031 actually contributes mightily to the national economy in a variety of ways. Let’s look at both sides of the debate in greater detail.

Section 1031 as a Tax Loophole

Under Section 1031, taxpayers are able to defer capital gains tax when they exchange their business or investment property for another property of like-kind (which essentially means another business or investment property). In practice, this can mean the deferral of hundreds of thousands ? and even millions ? of dollars in capital gains tax which would otherwise be collected by the federal government.

Though no lawmaker questions the permissibility of like-kind exchanges as they have developed under current regulations, there is doubt as to whether Section 1031’s true purpose was to defer gain in this particular way. The roots of Section 1031 stretch all the way back to 1921; at that time, however, the exchanges typically consisted of neighboring farmers who wished to swap their property in order to clarify property lines. Numerous common law opinions which occurred decades later shaped the current Section 1031 industry. Though it’s clear that like-kind exchanges do confer at least some benefits to the wider economy, it would be hard for even the most fervent 1031 supporter to deny that current like-kind exchanges are conducted with the same underlying purpose as those which occurred many decades ago.

Section 1031 as an Engine of Economic Activity

On the other side, many (if not most) professionals in the real estate industry contend that Section 1031 benefits the national economy in myriad ways. For one, they claim that Section 1031 encourages economic activity beyond the exchange itself in the form of construction services, title insurance services, real estate agent services, and so forth. Curtailing or eliminating Section 1031 would simultaneously reduce this related economic activity as well.

Furthermore, at least one formal study has concluded that the vast majority of like-kind exchanges eventually result in a taxable sale. In addition to supporting claims about the general economic benefit of 1031, a study by Professors David C. Ling (of the University of Florida) and Milena Petrova (of Syracuse University) stated that as high as 88 percent of exchanges ultimately result in taxable sales.

In our financially troubled state, Section 1031 faces arguably its toughest challenges. We shall have to wait and see whether this decades-old provision will either be preserved or meet its demise.

Image credit: Nicci Romanovsky

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Seattle CPA+John Huddleston has written extensively on tax related subjects of interest to small business owners. He is a graduate of Washington State University and the University of Washington School of Law.

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