Prominent Senator Takes Aim at Section 1031 Like-Kind Exchanges

A prominent Senator, Max Baucus (D-Montana), has unveiled a draft proposal that would sharply reduce or eliminate a number of tax breaks currently enjoyed by real estate investors.

Specifically, the draft proposal would eliminate Section 1031 “like-kind” exchanges.

It would also lengthen the current depreciation schedule under MACRS from 39 years for commercial property and 27.5 years for residential property to 43 years for both.

Furthermore, the change would be retroactive. That is, the federal government, under Baucus’s proposed rule, would “claw back” part of any deduction anyone has claimed for all property currently being depreciated.

The law would also treat all housing gains as ordinary income, to the extent the house has been depreciated or could have been depreciated under the straight-line method. Under the current law, capital, gains are hit with a 25 percent tax on any excess depreciation anyone may have taken on a property that would have been in excess of the amount taken under the straight-line method. The law, if passed, would convert that 25 percent capital gain into ordinary income, with a generally less favorable tax rate. “This could be a big hit to investors and owners of commercial real property,” said Evan Liddiard, a spokesperson for the National Association of Realtors®, in a statement.

Baucus would also disallow Section 179 deductions for qualified real property. While most real estate doesn’t qualify for immediate first-year expense write-offs under Section 179, the law does currently make exceptions for qualified leasehold improvements, qualified restaurant property and qualified retail investment property. The law was originally designed to help spur investment, because investors could get better cash flow earlier, making money available for reinvestment and therefore a better IRR, or internal rate of return.

Finally, the draft proposal would eliminate deductions under Section 179(d). This part of the law allows for a deduction of $1.80 per square foot for energy-efficient construction for commercial building construction.

All told, the combination of measures would amount to a significant tax increase for some investors, and a major compliance and tax-planning headache as CPAs try to figure out the retroactive tax on depreciation … and explain it to their clients.

Baucus isn’t some obscure back-bencher or a first-term junior Senator, either. He’s the chair of the Senate Finance Committee, and deeply involved in making fiscal policy.

Furthermore, he has little to lose being the point person for this possibly unpopular legislation, since he has announced he will not be running for re-election.

Congress has been looking hungrily at the Section 1031 like-kind exchange program for some time. Revenue is tight, by any standard, whether you are a fiscal hawk or dove. According to the Joint Committee on Taxation, the Section 1031 deferral is estimated to cost the Treasury about $18 billion in revenue over the next 10 years, according to an October 27, 2011 Revenue Memorandum.

The Center for Budget Policy and Priorities lays out the case against the Section 1031 like-kind exchange tax deferral in a report, and concludes: “The like-kind exchange provision is a strong candidate for reforms to rein in its expenses or repeal it.”

The Federation of Exchange Accomodators – a trade group that represents firms that act as intermediaries for Section 1031 like-kind exchange programs, is fighting for the industry’s very existence. The FEA took exception with the CBPP’s characterization of Section 1031 as a tax break for the rich: “On the contrary, it is one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000.”

The FEA also argues that the like-kind exchange does not eliminate tax on gains on exchanges of like-kind properties, such as investment real estate. Instead, it just defers it (though the FEA does not address the CBPP’s point that if the property owner dies, the tax obligation disappears thanks to the step-up in basis available to the heirs).

Other arguments the FEA musters include:

  • The 1031 encourages investors to reinvest within the United States, where they enjoy the tax deferral.
  • The deferral encourages continuous capital investment in equipment as well.
  • Because many transactions simply would not happen without the deferral on taxes from like-kind exchanges, repealing Section 1031 would significantly retard the velocity of the economy – meaning that fewer transactions would take place per year. The resulting spillover effect would mean fewer properties in the hands of those most willing and able to develop them into homes, stores, restaurants and working warehouses, offices, etc. – which translates to fewer jobs and fewer opportunities for all.

The FEA takes issue with the CPBB’s call for repeal of Section 1031 and states: “The real world has proven just the opposite. Tax-deferred exchanges are a vital stimulant to our economy. Taxing the gain on assets held for investment and business use would not be a tax on wealth; rather it would result in a tax on operating cash flow. §1031 not only encourages reinvestment over profit taking, it provides a strong incentive to keep that investment at home, in the United States.”

The Baucus proposal is a long way from passing. Right now, the Senator has just floated the proposal and is seeking public comment. The National Association of Realtors® has come out as opposed and is formulating its response. Not a single Republican is in support, according to the NAR.

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