model house on a Jenga stack illustrating the like-kind exchange rules risk in 2017

Are the “Like-Kind” Exchange Rules at Risk in 2017?

“Like-kind” exchanges are a popular investment option that allow individuals and businesses to defer paying capital gains tax on a variety of assets – including real estate – at the time of sale by simply exchanging one “like-kind” investment for another of equal or higher value. As long as you meet certain qualifications, you can “kick the can” up the road indefinitely, avoiding taxes along way.

It’s easy to see why this nearly 100-year-old piece of the IRS tax code is so popular. However, because the federal government loses tax revenue this way – an estimated $40 billion dollars’ worth in revenue over a ten-year period – the “like-kind” exchange rules are periodically in jeopardy. For instance, President Obama proposed to phase out the capital gains tax exemption on personal property, such as art and other collectables, by 2016.

How are 1031 exchanges likely to fare in 2017 and beyond? Let’s take a look.

First, Some 1031 Basics

“Like-kind” exchanges originated in the 1920s to reduce the burden on farmers who were looking to swap land. If the proceeds of the sale were completely bound up in a new purchase, paying taxes would hinder the land-poor farmer from expanding his business indefinitely.

The same logic applies today. Businesses like airlines take advantage of the 1031 exchange to upgrade expensive equipment, and it has become a powerful tool for real estate investors to build portfolio wealth, in large part because there is a lot of flexibility in what you can purchase. You can sell several properties in exchange for a single investment or to use the exchanges to buy or sell replacement property interests (RPIs), provided that you meet the following qualifications:

• You identify, in writing, up to three replacement properties within 45 days of the original sale and purchase at least one of them within 180 days.
• You use a qualified intermediary to handle the proceeds – none of money from the sale can go to you, personally.
• The properties are investment only; you cannot live in them yourself.

Moreover, if you die before the investment is sold, and the cost basis falls under the threshold for the estate tax, your heirs inherit the investment tax-free.

Are 1031 Exchanges Too Much of a Good Thing?

Although 1031 exchanges deprive the government of tax revenue, they also serve as an important economic stimulus. A 2015 analysis by Ernst & Young found that repealing or limiting the tax code could lead to a decline in the GDP of approximately $8 billion per year. Eliminating 1031 exchanges would disproportionately affect small businesses and real estate professionals, but the larger population would pay for the change indirectly in the form of higher priced goods, rent, and services.

It seems unlikely that the government would vote to eliminate a portion of the tax code that benefits real estate investments, as they are a big portion of keeping the economy stable. However, some proposed revisions to the tax code could potentially make “like-kind” exchange rules less attractive for average investors. House Republicans want to eliminate half of capital gains tax and tax the remainder like income. They also want to collapse the tax rates in order to reduce the highest marginal rate, eliminate the estate tax, get rid of state tax deductions, and raise the standard deduction.

Cumulatively, these changes to the tax code would raise taxes on some middle-class earners while taking away their ability to benefit from a 1031 exchange. Corporations and high income earners who are dealing in multi-million dollar transactions, on the other hand, would stand to reap huge benefits. They would still be able to shelter income from taxes through a “like-kind” exchange, and at the same time, they would be able to keep their wealth intact for generations without ever paying federal income tax.

The Bottom Line?

For some private real estate investors, proposed changes to the tax code could make real estate investments in 2017 a much less attractive proposition. That’s not because 1031 exchanges will be eliminated per se but because the proposed changes eliminate a lot of tax breaks for the small investor.

About Peak 1031 Exchange, Inc.

Peak 1031 Exchange, Inc., a leading national provider of tax-deferred 1031 exchange services, combines cutting-edge technology, personalized service, and a detailed-oriented approach. They help private investors and larger entities understand the complexities of valid exchanges, including up-to-date information about how changes to the tax code will affect opportunities for investment. Keep in mind, with any investment it is wisest to consult your tax advisor as the benefits to these financial scenarios vary on a case by case basis.