High income New York City residents selling fully depreciated real estate this year will incur a capital gains tax of about 39 percent, consisting of a federal tax of 28.5 percent (25 percent on IRC §1250 unrecaptured gain plus 3.8 percent under IRC §1411) and a New York tax of 12.5 percent [6.85 percent to NYS (if taxable income exceeds $2 million, the marginal rate increases to 8.82 percent) and NYC tax of 3.65 percent]. However, taxpayers who decide to swap their property in a like kind exchange will incur only a transfer tax, which is 0.4 percent for nonresidents of New York City, and 3.05 percent for New York City residents. While like kind exchanges have become a fixture of the tax law, Washington, like a dog roused from its sleep by an intruder, has recently become perplexed by the foregone tax revenues occasioned by like kind exchanges. By most accounts, Section 1031 will live to see another tax year. However, it is worth noting well that no longer are like kind exchanges “below the radar” of either the Congress or the President.
Thus, in its 2010 Report, “The President’s Economic Recovery Advisory Board” discussing “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.” 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. Although there is no bill on the floor of the House or Senate, like kind exchanges have aroused the attention of both the Senate Finance Committee and the House Ways and Means Committee. Congressman Dave Camp (R-Mich), Chairman of the House Ways and Means Committee, currently presides over a bipartisan tax reform working group examining Section 1031. In 2005, based upon a total of 408,577 tax returns filed (293,676 of which were individual) total deferred gain in like kind exchanges entered into by individuals, corporations and partnerships totaled $1.01 trillion. Individuals accounted for $41.4 billion of that deferred gain.
In 2010, based upon data from 241,587 returns (158,299 of which were individual) the total deferred gain from reported like kind exchanges reported had diminished to $39.9 billion. However, although accounting for nearly two-thirds of the filed returns in 2010, individuals accounted for only $2.72 billion of the deferred gain. The 64,401 corporate returns filed accounted for $31.26 billion, or 78 percent of the deferred gain. Source: Internal Revenue Service “Form 8824 Data for Tax Years 1995-2010.”
The following are among the proposals of “working groups” of the Joint House and Senate Committee: (i) retaining present law like-kind exchange rules in their entirety, including the requirement for qualified intermediaries; (ii) retaining present law like kind exchange rules but simplifying the deferred exchange regulations with respect to qualified intermediaries; (iii) modifying rules to allow foreign real property to be exchanged for U.S. real property (but continue to exclude exchanges of U.S. property for foreign property); and (iv) imposing capital gains tax on like-kind exchanges and requiring an exchange broker to file an information return reporting the amount realized.
New York Times Reports Perceived Abuse Under Section 1031
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 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.” 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. Therefore, imposing capital gains on like kind exchanges seems to be a contradiction in terms. In any event, whatever the report is alluding to, it is not an auspicious development. When one considers the fact that 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 fate of Section 1031 (and perhaps other deferral provisions in the Code which constitute tax expenditures) does appear less certain.
New Yorkers & Californians Would Suffer Disproportionately
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 taxpayers living in those jurisdictions, the elimination of tax deferral would not only result in the imposition of a hefty federal income tax, but it would also result in a bonanza to New York and California.Lobbyists from the Federation of Exchange Accommodators have descended upon 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 Schumer (D-NY), a member of the Senate Finance Committee, or Congressman Charles 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 pressure to diminish the tax benefits of Section 1031. Nevertheless, it is unclear whether Republicans would favor the elimination or even the curtailing of tax benefits provided under Section 1031, since that would increase taxes for wealthy Americans and corporations, who form a base of the party.
Reasoning of Those Favoring Reform of Section 1031 Flawed?
The reasoning of those who would curtail the deferral provided by Section 1031 appears to be flawed for a number of reasons: First, those who favor reform or repeal implicitly assumes that those taxpayers who would engage in like kind exchanges would also engage in a taxable exchange if Section 1031 were repealed. If Section 1031 were repealed or its application were limited, there is no indication that many of the tax-free exchanges would become taxable exchanges. Many persons who engage in like kind exchanges might hold their property rather than engaging in a taxable exchange.
Second, many persons engage in multiple exchanges over the years, and “trade up” multiple times. Therefore, when interpreting the statistics for deferred gain, one must bear in mind that deferred gain for the same property may appear multiple times if there have been multiple exchanges.
Third, if Section 1031 were repealed and taxable sale were to transpire, 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 1013 exchanges is due to appreciation that occurred over many years. Once that gain is tapped and taxed by the Treasury, the reservoir of deferred gain available for future capital gains tax will have been depleted. Like known oil reserves, the reservoir of deferred gain is finite and subject to depletion. Accordingly, while it is true that repeal of Section 1031 would result in substantial revenues for Treasury, a number of factors — some of which are incalculable due to their unpredictability — suggest that the revenues generated by repeal could be transient.
Finally, Congress enacted the predecessor to Section 1031 nearly a century ago to prevent the taxation of gains where the investment continued unimpeded in substantially the same form. From a policy point of view, the argument for not taxing “paper gains” where the investment continues in nearly identical form is no less persuasive today than it was in 1928, when Section 112(b)(1), the predecessor to Section 1031, was first promulgated.
If one were to prognosticate, it would appear that there is little likelihood that any changes — substantive or not — to Section 1031 will occur in 2014. For the moment, Congressional attention appears to be focused elsewhere. Hopefully, like past baseball stars whose admission to the hall of fame comes tantalizingly close in early years, but then fades as younger stars become eligible, and the older stars become forgotten, one may hope that the momentum for reform or repeal of Section 1031, which traces its lineage almost to the enactment of the income tax itself in 1918, will subside and eventually reverse direction.