Like Kind Exchanges in Crosshairs of President Obama and Congress

The Joint Committee on Taxation recently released its estimates of federal tax expenditures for the years 2012 through 2017. The five-year cost for Section 1031 was estimated to be $42 billion, which exceeded previous estimates. Congressman Dave Camp (R-Mich), Chairman of the House Ways and Means Committee, currently presides over a bipartisan tax reform working group last convened in September, which is examining Section 1031. In its 2010 Report, “The President’s Economic Recovery Advisory Board” in its discussion of “options for simplifying the taxation of capital gains,” suggested the “option” of “limit[ing] or repeal[ing] the special treatment of like-kind exchanges under section 1031.”  Although there is no pending legislation on the floor of the House or Senate relating to Section 1031, tax revenues lost through like kind exchanges have now attracted the keen attention of both the Senate Finance and the House Ways and Means Committees.

Arguments in Favor of Repealing Like Kind Exchanges Suffer From Defects in Logic

The reasoning of those who would limit the application of Section 1031 appears to be faulty, for two principal reasons: First, the argument implicitly assumes that those persons who would engage in like kind exchanges would engage in a taxable exchange if Section 1031 were repealed.  If Section 1031 is repealed, many of the exchanges which now produce deferred gain will not transpire.  Second, many persons engage in multiple exchanges over the years.  If Section 1031 were repealed and a taxable sale transpired, deferred gain would no longer be present in the future, unless real estate prices rose substantially.  Much of the gain now being deferred in Section 1031 exchanges is due to appreciation over many years.  Once that gain is taxed, the reservoir for future capital gains tax will have been depleted.  Accordingly, while it is no doubt absolutely true that the repeal of Section 1031 would result in substantial revenues for Treasury, a number of factors, some of which are incalculable due to their unpredictability, could suggest that the revenues generated by repeal could be transient.

In 2010, based upon data from 241,587 returns (158,299 were individual) the total deferred gain from reported like kind exchanges reported had diminished to $39.9 billion. Although accounting for nearly two-thirds of the filed returns, individuals accounted for only $2.72 billion of the deferred gain. The 64,401 corporate returns accounted for $31.26 billion, or 78 percent of the deferred gain.  Corporations are clearly benefitting from like kind exchanges. However, the corporate tax rate in the United States is among the highest in the world.  Eliminating like kind exchanges could impede economic recovery.  Former Federal Reserve Chairman Alan Greenspan has long advocated eliminating capital gains entirely.

The following are among proposals of “working groups” of the Joint House and Senate Committee: (i) Retain present law like-kind exchange rules in their entirety, including the requirement for qualified intermediary (“QI”) in a like-kind exchange: (ii) Retain present law like-kind exchange rules but simplify the deferred exchange regulations requiring qualified intermediaries; (iii) modify rules to allow foreign real property to be exchanged for U.S. real property (but continue to exclude exchanges of U.S. foreign property); and (iv) impose capital gains tax on like-kind exchanges and require an exchange broker to file and information return reporting the amount realized.

New York Times Asserts Like Kind Exchanges Are Inappropriate Tax Expenditures

The perceived abuse by corporations resulted in two articles appearing in the New York Times, the first of which appeared on January 6, 2013, and was entitled “Major Companies Push the Limits of a Tax Break.”  The article concluded that like kind exchanges were “divert[ing] billions of dollars in potential tax revenue from the Treasury each year.” The opening paragraph of the article read:

“It began more than 90 years ago as a small tax break intended to help family farmers who wanted to swap horses and land. . . Over the years, however, as the rules were loosened, the practice of exchanging one asset for another without incurring taxes spread to everyone from commercial real estate developers and art collectors to major corporations.  It provides subsidies for rental truck fleets and investment property, vacation homes, oil wells and thoroughbred racehorses, and diverts billions of dollars in potential tax revenue from the Treasury each year.” Another article appeared in the New York Times on March 16, 2013; this piece stated that “[g]overnment estimates say [like kind exchanges] cost about $3 billion a year, but industry data suggest the amount could be far higher.”

Outlook For Like Kind Exchange Legislation in 2014

Notably, one of the options considered by Congress would drastically change current law by imposing capital gains tax on like kind exchanges.  It is unclear what this means, as the raison d’etre of section 1031 is to defer capital gains, and imposing capital gains on like kind exchanges seems to be a contradiction in terms.  In any event, whatever the report is alluding to, it can no longer be said that like kind exchanges are “under the radar.” Revenues from estate taxes have diminished from approximately $75 billion in 2008 to less than $10 billion in 2012, and no one expects estate tax revenues to return to their previous levels.

The elimination of favorable tax treatment for like kind exchanges would be particularly detrimental for New Yorkers and Californians, among others whose states impose substantial income tax.  For those persons, the elimination of favorable tax treatment for like kind exchanges would not only result in a new federal income tax of up to 23.8 percent (not including Section 1250 unrecaptured gain), but would also result in a new state income tax of up to 10 percent for New Yorkers not residing in the city, and up to 13 percent for New York City residents and Californians.  Lobbyists from the Federation of Exchange Accommodators (FEA) have visited Washington in an effort to “educate those on Capitol Hill about the benefits of using 1031 Like-Kind Exchanges.”

It is unclear whether Senator Charles E. Schumer (D-NY), a member of the Senate Finance Committee, or Congressman Charles B. Rangel (D-NY), a member of the House Ways and Means Committee (and former chairman) would support legislation eliminating or curtailing the tax benefits of Section 1031.  However, a desire on the part of Congressional Democrats to shift the tax burden to wealthier taxpayers such as corporations and high income individuals, combined with a desire of Congressional Republicans to reduce taxes, could result in a “perfect storm” to diminish the tax benefits of Section 1031. Nevertheless, although Republicans have stated that they seek to reduce the deficit, it is not clear whether Republicans would favor the elimination or the curtailment of tax benefits under Section 1031.

If one to predict — never an easy task when the U.S. Congress is involved —  it would appear that there exists a substantial possibility that as the housing market continues to recover, some statutory changes in Section 1031 could occur in 2014.  For the moment, the attention of both President Obama and Congress appears to be focused on Health Care Reform, something which Mr. Obama clearly wishes to be part of his legacy as President. Good or bad, this may divert attention of Congress from tax reform in general, and Section 1031 in particular.