Section 1031 (§1031) of the Internal Revenue Code has encouraged investment, created jobs and stimulated the United States economy for almost 100 years by permitting tax deferral on the like-kind exchange of business and real estate assets.
Despite the extensive use of §1031 exchanges in the real estate and aircraft industries, there has been a movement on Capitol Hill to revamp or completely repeal §1031 as part of comprehensive tax reform.
In 2014, former House Ways and Means Committee Chairman Dave Camp (R-MI) submitted a tax reform proposal to repeal §1031 and use the additional tax revenue to finance a lower corporate income tax rate. More recently, in 2016, House Ways and Means Committee Chairman Kevin Brady (R-TX) proposed a plan commonly referred to as the “Blueprint for Tax Reform.”
While the “Blueprint” does not specifically mention §1031 exchanges, an unintended consequence of its recommendation for full expensing of capital expenditures, except land, may be the elimination of §1031, which, according to experts, will have a significant adverse impact on the United States economy.
According to a November 2015 macroeconomic study by Ernst & Young titled “Economic Impact of Repealing Like-Kind Exchange Rules,” the repeal or limitation of §1031 would not only have an adverse impact on the real estate industry, but it would also significantly affect the economy as a whole and result in the following:
- Estimated negative economic impact of $27.5 billion per year to the top ten sub-industries that engage in like-kind exchange activity (e.g. real estate, transportation, construction, oil and gas, equipment rental and leasing, etc.)
- Overall reduction of approximately $8.1-$13.1 billion annually to the United States gross domestic product (GDP)
- Increased costs of capital and greater reliance on debt financing
- Slower economic growth
Another study titled “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate” analyzed more than 1.6 million real estate transactions from 1997 to 2014. The study was conducted by Dr. David Ling, a finance professor at the University of Florida, and Dr. Milena Petrova, a finance professor at Syracuse University. The following is a summary of their findings regarding the advantages of §1031 exchanges and the impact if §1031 is repealed:
- Advantages of §1031
- Encourages investment and promotes sales activity in commercial real estate
- Redeploys capital to expand and upgrade buildings
- Creates jobs
- Impact of Repeal of §1031
- Decline in property values
- Decreased construction activity
- Higher rents, reducing the affordability of commercial space for tenants
Finally, according to the study by Ling and Petrova, the State of Arizona is among several states that account for a disproportionate share of §1031 exchanges. As a result, the repeal of §1031 could have a significant negative economic impact on the future of Arizona’s economy.
According to Rick Wittstock, vice president – Arizona, Investment Property Exchange Services, Inc. (IPX1031®), “Our clients, many of whom are small businesses and middle class taxpayers, are growing their businesses and increasing their nest eggs through like-kind exchanges of rental properties, ranches and farms, machinery and equipment. The tax deferral provided by §1031 encourages and enables our clients to invest more capital into their replacement properties, which results in rejuvenated properties, improved communities, jobs and taxable income for contractors, suppliers, lenders, and others, along with increased economic activity, and state and local transfer, property and sales taxes. Simply stated, everyone benefits.”
Howard J. Weiss is a member at Jennings, Strouss & Salmon, P.L.C. in Phoenix, Ariz. His practice is focused on counseling clients regarding the purchase, sale, and lease of commercial real estate, as well as business transactions and entity formation. The information contained in this column is for informational purposes only, and should not be construed as providing legal advice or tax advice. If you have any questions regarding the topics discussed herein, you are advised to contact an attorney or tax advisor.