24A — April 14 - 27, 2017 — Financial Digest — M id A tlantic
Real Estate Journal
F inancial D igest By John Harvey CPA, MBT, Cornerstone Real Estate Investment Services Ltd. Tax reform threatens IRC Section 1031 T ax reform in 2017 may eliminate the Inter- nal Revenue Code Sec-
(most transactions being taxed at either the 12.5% or 16.5 percent rate), and any allowed or allowable deprecation of the improvements would need to be recaptured at ordinary income tax rates (most at 25% and 33%). In addition, there may be state taxes on the gain if the property were situated in an income tax state. These taxes would conceivably be payable as a tax withhold- ing at the time of sale, as an estimated tax payment in the quarter the sale occurred, or by the due date of the seller’s tax return. A Possible Solution In the author’s opinion, the best solution may be found in President Trump’s campaign tax plan. The President’s plan would allow immediate ex- pensing to manufacturers and allow real estate to continue to prosper as it has for nearly 100 years under §1031. This could be accomplished with a simple line item in the new tax legisla- tion that exempts section 1250 property from the immediate expensing rules (1250 property includes real estate and real property subject to deprecia- tion that is, and has not been, section 1245 property used in a business). This approach would also accomplish many of the goals set forth in the House Blueprint. Section 1031 promotes sav- ings and investment. Think about how much of America’s savings is in land alone, not to mention the improvements. The Federal Reserve’s Flow of Funds report contains enough data to calculate the value of privately held land in the U.S. at $14.488 trillion 3 . If immediate expensing replaces §1031, all this savings would be punished by being taxed. In most cases, land savings are ultimately exchanged using §1031 into income-producing property to fund retirement as the land owner ages. These savings are therefore indis- pensable to fund a large seg- ment of the population’s re- tirement especially given the challenges to funding Social Security. Tax reform that would tax land previously un- taxed under §1031, land that comprises much of the sav- ings for farmers and ranchers, would seem to be at odds with the Blueprint’s purpose of a fairer tax code. Promote Savings and Investment
to acquire property purely for the tax benefit of immediate expensing, the Blueprint will take away the deductibility of the business interest ex- pense—making mortgage in- terest expense non-deductible for real estate investments. According to the Blueprint, the immediate expensing de- duction could be netted against other capital gains and passive income in the year of the ac- quisition. Several members of Congress have commented to Cornerstone that they under- stand the intent of the Blue- print is to also allow the im- mediate expensing deduction to also be applied to ordinary (earned) income, and that the passive loss rules created by the Reagan Tax Reform Act of 1986 would not apply. Any remaining loss generated by the deduction could not be car- ried back but would be carried forward indefinitely. Taken by itself, immediate expensing appears to be an amazing tax shelter allowing a taxpayer to shelter multiple year’s income (even ordinary income) from federal tax fol- lowing a large investment property acquisition. Per the Tax Foundation, immediate expensing will cost the federal budget over $2.2 trillion over a ten-year period. However, if the taxpayer is selling an investment property with the intent to continue his or her investment in real estate in the form of a replacement property, there could be a potentially significant tax exposure under an immediate expensing re- gime that has not been present under §1031. The Threat to Section 1031 The authors of the Blueprint have commented that that given the Blueprint’s lower capital gain tax rates and the provision for immediate ex- pensing they don’t think that §1031 would be necessary. If §1031 exchanges were eliminated during the tax re- form process, a taxpayer would need to recognize the gain at- tributable to both the land and improvement component of the real estate when sold. Accord- ingly, it would be necessary for the sales price to be allocated between the land and improve- ments in the sales contract. The pure capital gain on the transaction for both the land and improvements would be taxed at the lower capital gain rates set forth in the Blueprint
GenerateEconomicGrowth Section 4 of the Blueprint focuses on economic growth, and immediate expensing would be a key tool in accom- plishing that grown through tax reform. While there are as yet no studies on the eco- nomic growth that immediate expensing would provide, it should be noted that the Tax Foundation in 2016 reported that GDP growth would shrink by $18 billion dollars each year if §1031 like-kind exchanges were repealed. An earlier study by Ernst and Young re- ported a $13 billion yearly GDP contraction if §1031 were repealed. A key component to the eco- nomic vibrancy and growth that §1031 like-kind exchanges provide for the economy is the turn-over effect. As there are currently no tax conse- quences under §1031 to selling an investment property and replacing it with a like-kind property of equal or greater value, there is no tax friction that discourages the turnover of investment property. Con- sequently, properties change hands at a greater rate. The new buyers often improve the property and “make it their own” by painting, improving, buying furniture and other fixtures, all of which benefit local industries such as real estate agencies, contractors, title insurers, lenders, equip- ment dealers, manufacturers, transportation, energy, and agriculture. In addition, city budgets and local schools also benefit from the turnover of real estate through new property value assessments. Immediate expensing, on the contrary, would discourage turnover and produce a lock- in or buy-and-hold culture, as a sale would generate signifi- cant taxes from capital gain, depreciation recapture, and state taxes. Finally, it should be noted that §1031 is not a tax exclu- sion but a tax deferral. While there is a temporary deferral of capital gains which are taxed at lower rates, the rental income from the replacement property is taxed each year at higher ordinary income tax rates. Per a study by Ling and Petrova 4 , 88% of the real estate replacement properties ac- quired in a §1031 exchange are ultimately disposed of through a taxable sale, so eventually the tax does get paid.
Summary A broad coalition of industry associations and organizations is engaged in efforts to alert lawmakers that §1031 needs to remains in the tax code. At this time the 100 plus member coalition includes the Federa- tion of Exchange Accommoda- tors (FEA), the REALTORS ® Land Institute, the National Association of REALTORS ® , and the Alternative Direct Investment Securities Asso- ciation (ADISA) among others. Like-kind exchanges should be integral and complementary to tax reform, as §1031 exchanges promote economic growth, gen- erate jobs, and benefit multiple industries, all while reducing taxes and the burden of tax compliance. Please make your voice heard by sending a letter to your federal legislators, to let them know how critical §1031 is to you and to your business at www.1031taxreform.com/ take-action/. John Harvey is president and owner of Cornerstone Real Estate Investment Services. n Harvey holds a Master of Business Taxation and a Bach- elor of Science in Account- ing from the University of Southern California Leventhal School of Accounting. Harvey has been a licensed CPA since 1991, and has worked as a Se- nior Manager with Deloitte & Touché in Los Angeles. Harvey is an Elite Adviser for Cor- nerstone, assisting investors in the purchase of over $500 million in tenants-in-common and Delaware Statutory Trust real estate. He is an affiliate member of the Federation of Exchange Accommodators (FEA) and a member of the Alternative Direct Invest- ment Securities Association (ADISA). 1 Starker v. United States, 1979, retrieved 2007-07-04 ; Starker v. United States, 602 F. 2d 1341 - Court of Appeals, 9th Circuit 1979. 2 Suzanne Baker, SECTION 1031: LIKE-KINDEXCHANGES: CURRENT THREATS TO A HUNDRED YEAR OLD TOOL 3 FEDERAL RESERVE STA- TISTICAL RELEASE, Z.1 Finan- cial Accounts of the United States, Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts, Fourth Quarter 2016. 4 2016 Ling and Petrova Study “the Economic Impact of Repeal- ing or Limiting Section 1031 Like- Kind Exchanges in Real Estate”.
t i o n 1 0 3 1 l i k e - k i n d e x c h a n g e , according to Sen i or Re - publican law makers. Sec- tion 1031 has been a vital e c o n o m i c
stimulant and part of the tax code since 1921. A study of the early tax court cases clearly shows that the two key purposes for the provision were (1) to avoid unfair taxa- tion of ongoing investments in property and (2) to encourage active reinvestment 1 . The use and dependence on §1031 ex- changes have grown over the past nearly 100 years to be a major underpinning of today’s national economy. Farmers and ranchers in the agriculture community have the broadest use of §1031 like-kind exchanges to combine acreage, acquire high grade land, exchange breeding stock and upgrade farmmachinery 2 . In addition to hard working farmers and ranchers, §1031 like-kind exchanges are used by individuals of modest means and small businesses. Accord- ing to Cornerstone Real Estate Investment Services, a leading replacement property broker- age, in over half a billion dol- lars in exchange transactions over a period of a 14-year peri- od, its average §1031 exchange transaction was a modest $288 thousand. Furthermore, the National Association of RE- ALTORS ® reports that 40% of all realtors state that without §1031 exchange many of their residential rental property transactions would not have occurred; some 63% of all re- altors have participated in a §1031 exchange. The Blueprint A major component of the Blueprint to achieve job growth and economic stimulus is a pro- vision to allow for the immedi- ate 100% expensing of all busi- ness investments. As defined by the Blueprint, business investments would include both investments in tangible property (such as equipment and buildings) and intangible assets (such as intellectual property). However, the im- mediate expensing will not apply to land. In addition, to discourage the use of leverage
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