The incoming Trump administration and Republican Congress will soon enjoy a tremendous opportunity to enact comprehensive tax reform, but one important, nearly 100-year-old investment vehicle may hang in the balance.
"Like-kind" exchanges, otherwise known as section 1031 exchanges, have encouraged capital reinvestment for individual property owners, small businesses and large corporations since 1921.
Under Section 1031 of the United States Internal Revenue Code, the exchange of certain types of property may defer the recognition of capital gains or losses due upon sale, and hence defer any capital gains taxes otherwise due.
But after Congress' Joint Committee on Taxation estimated in 2014 a tax-revenue gain of $40 billion by repealing Section 1031 over 10 years, President Obama proposed a $1 million cap on 1031 tax savings in 2014 and then, in 2016, to completely eliminate exchanges of collectibles, artwork and other personal property, which are also allowed under a 1031 exchange.
In a 1031 exchange, an individual or company can trade up older and less-expensive investment properties, or equipment such as rental cars and airplanes, for newer, pricier ones. By doing so, they can defer paying capital gains taxes until an eventual sale, allowing investors to reinvest in their businesses.
If, at death, the asset has not been sold or exchanged, the cost basis is stepped up so no taxes are owed, as long as it falls under the threshold for owing estate tax. However, about 88 percent of 1031 exchange transactions result in eventual taxation, said Steve Chacon, vice president of exchange service operations for Accruit and president of the industry trade association Federation of Exchange Accommodators.
Experts say caps or restrictions to 1031 exchanges would be chilling to the economy; airline, construction and rental-car companies save millions annually by exchanging older assets for new ones. Should their 1031 savings be capped, the cost of everything for the consumer would go up and the real estate industry would be hit hard, said Scott Saunders, FEA board member and senior vice president at Asset Preservation in Colorado Springs, Colorado.
A 2015 analysis by Ernst & Young found that either repeal or limitation of like-kind exchanges could lead to a decline in GDP of about $8 billion annually. It accounts not only for stagnate business activity but also loss of work "ancillary" providers, such as brokers, appraisers, insurers, lenders, contractors and manufacturers.
Last year a National Association of Realtors member survey found that 63 percent of Realtors participated in a 1031 exchange over the past four years. About 40 percent of respondents said that, without them, those transactions would not have occurred at all. About 56 percent said the projects would have been smaller in scale.
President-elect Trump has proposed that investments valued over $10 million and held until death would be taxed at the capital gains rate, with an exemption for "small business" and family farms. A Trump transition team spokesperson did not return an email for comment by publication time.
Now's the time to start thinking about how a 1031 exchange may be used as an investment and estate-planning tool, particularly in real estate, with a few important considerations:
1. Make sure your investment is "like-kind." To be eligible for the tax benefits of a 1031 exchange, you must exchange "like" investments of equal or greater value, reinvesting the net equity and having the same or greater amount of debt. Most commonly it is investment property, though it could also be art, collectibles and equipment.
The property must be held for investment and not for personal use, such as a primary residence or property rented to family members for less-than-market rent, said Nancy Grekin of Honolulu-based firm Grekin Law.
"The courts, in recent years, have cracked down as what is 'like kind' for an exchange," said Crystal Stranger, an enrolled agent and president of 1st Tax, also in Honolulu. She cited the recent case of VIP's Industries & Subsidiaries v. Commissioner of Internal Revenue, which disallowed a 1031 exchange from leasehold property with a term remaining of 30 years to fee simple.
2. Be ready to quickly find replacement property. The IRS requires investors to identify, in writing, up to three replacement investments (more with certain market value requirements) within 45 days of selling their former, which is done by a qualified 1031 intermediary, who is required by law to handle reporting and compliance with the sale.
The investor is not allowed to hold or have access to the money, so the intermediary needs to be brought in before the closing of the sale. You'll need to close on the new investment no later than 180 calendar days after selling the relinquished property, said Saunders at Asset Preservation.
You can also do the transaction in reverse, having an entity owned by the intermediary buy the new property first, but only if you have liquid funds in the bank to loan to the intermediary and be reimbursed after the relinquished property is sold, Saunders said.
The replacement property must be equal to or greater than the one being exchanged, and you can switch out one larger property for several smaller ones, or sell several smaller properties to buy one larger one, Saunders said. If you don't reinvest all of the funds from the sale, those monies will be taxed on depreciation recapture, federal capital gains, state taxes and net investment income.
3. Choose a reputable intermediary. Although a few states do regulate 1031 intermediaries, the federal government does not, which means you'll want to choose the company that is handling your large chunk of money carefully, said Grekin at Grekin Law. Many large, nationwide title companies have 1031 intermediary subsidiary companies that are proficient in the transactions but do not "give the kind of structured advice that a tax lawyer would," she said.
Your funds should never be comingled with other funds, and make sure the intermediary is bonded and insured, she said. The FEA offers a list of qualified professionals on its website.
"Never, ever go to a very small outfit. If they go bankrupt while they're holding your money, per the contract, you can't touch it. It should never be an individual holding your money," Grekin said.
4. Determine if you need a 1031 exchange (you may not). "If you don't have enough gain, it may not be worthwhile," Grekin said. That's because you'll have to pay an intermediary to handle the transaction (the average cost nationwide is about $1,250) and meet the timing requirements.
Companies that are already carrying forward losses may not benefit from a 1031 exchange, said Chacon of Accruit. "It's all about timing cash flows," he said.
If you want to get out of the business you're in — say, you want to leave real estate for mutual funds — you cannot do an exchange, because of the "like-kind" rule, said Saunders at Asset Preservation, and you should plan for your tax liability.
Those who want to use an exchange as a tool to acquire better-performing investment properties throughout their lifetime should definitely consider Section 1031, he said, as well as any investor or business whose aim is to build wealth over a lifetime or grow their business.
"It allows investors to buy more productive real estate or equipment," said Accruit's Chacon. "And to preserve the continuity of their investment and be flexible in a rapidly changing economy."
— By Kayleigh Kulp, special to CNBC.com