Tax Policy, IRC 1031 and Politics

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This post is the first part of a two-part post describing a vital tax provision, IRC 1031. Part 1 will outline its operation and perceived benefits, while Part 2 will present some of the more common arguments against its use, and describe the misguided reasoning behind current legislative attempts to significantly change or eliminate IRC 1031. 

IRC 1031 is a provision of the internal revenue code that allows a taxpayer to exchange one business (or investment) property, for another property of like-kind, without recognizing gain or loss in the process. This provision causes a distinctly different result from a taxpayer exchanging one property for a like-kind property. In the latter sale transaction, the property is sold and the taxpayer pays tax on any gain in the property, and then can purchase a new property - or use the monies received otherwise. Through IRC 1031, a taxpayer is not avoiding the tax entirely, just deferring any gain until the property is sold for cash or a cash equivalent.  

This touches on one very important issue in tax and tax policy - when is the best time (for purposes of maintaining federal tax revenue) to tax a taxpayer. Generally, the short answer is when the taxpayer has realized the gain in the form of cash or a cash equivalent, as the taxpayer has liquid property to pay the tax. 

IRC 1031 is an extension of this policy - we only want to tax individuals when they realize gain by selling an asset in exchange for cash, because, having received legal tender for the investment, they are best situated to pay the tax, they have received property that can be used to pay the tax. 

On the other hand, if a taxpayer exchanges one investment for another  like-kind investment the taxpayer is not really in a position to pay the tax - they have received like-kind property of similar value; they do not have cash to pay the tax. Put another way, the individual has not "cashed-out" of the investment yet. This in turn, encourages businesses and investors to invest resources more efficiently without a tax burden as a barrier to such efficient investment. 

An excellent but very basic example is a Business Z, located in Town A, on real Property X. Real Property X is not suitable to Business Z, however, the owner of Business Z inherited the property from his parents, so it was available and feasible. However, due to the unsuitability of real Property X for Business Z, it has not realized great success in Town A, but is still valuable real property due to its size. There is another property in Town A, real Property Y, that is quite suited to Business Z and likely to significantly increase the foot traffic and quality of experience for customers of Business Z. It is much smaller than Property X, but similar in value due to its location. Business Z generally has three options, 1.) Find a means of financing and purchasing Property Y, while maintaining property X, which may not be economically feasible, 2.) Sell Property X, pay the taxes on any gain, then use the proceeds to help pay for purchasing Property Y and then obtaining financing for the rest, or 3.) Engage in a 1031 transaction. With 1031, business Z can simply swap X for Y, without paying taxes, and without having to concern himself or herself with financing because this is an exchange and not a sale and purchase. Business Z moves to Property Y and thrives. 

This important provision has likely been a significant factor in our economy’s recovery and without question, has been a key part of the real estate industry‘s recovery. Recently this important provision has come under attack from elected officials on both sides of the aisle, in an attempt to foot the bills being generated by the same elected officials, with very little consideration for the practical effect of such a change. 

In the next installment of this two-part article, I will address the argument that IRC Section 1031 represents a loophole, and the present efforts to significantly change or completely abandon IRC 1031 altogether.

- See more at: http://www.youngwooldridge.com/blog/tax-policy-irc-1031-and-politics/#sthash.hQuEhv0H.dpuf

This post is the first part of a two-part post describing a vital tax provision, IRC 1031. Part 1 will outline its operation and perceived benefits, while Part 2 will present some of the more common arguments against its use, and describe the misguided reasoning behind current legislative attempts to significantly change or eliminate IRC 1031. 

IRC 1031 is a provision of the internal revenue code that allows a taxpayer to exchange one business (or investment) property, for another property of like-kind, without recognizing gain or loss in the process. This provision causes a distinctly different result from a taxpayer exchanging one property for a like-kind property. In the latter sale transaction, the property is sold and the taxpayer pays tax on any gain in the property, and then can purchase a new property - or use the monies received otherwise. Through IRC 1031, a taxpayer is not avoiding the tax entirely, just deferring any gain until the property is sold for cash or a cash equivalent.  

This touches on one very important issue in tax and tax policy - when is the best time (for purposes of maintaining federal tax revenue) to tax a taxpayer. Generally, the short answer is when the taxpayer has realized the gain in the form of cash or a cash equivalent, as the taxpayer has liquid property to pay the tax. 

IRC 1031 is an extension of this policy - we only want to tax individuals when they realize gain by selling an asset in exchange for cash, because, having received legal tender for the investment, they are best situated to pay the tax, they have received property that can be used to pay the tax. 

On the other hand, if a taxpayer exchanges one investment for another  like-kind investment the taxpayer is not really in a position to pay the tax - they have received like-kind property of similar value; they do not have cash to pay the tax. Put another way, the individual has not "cashed-out" of the investment yet. This in turn, encourages businesses and investors to invest resources more efficiently without a tax burden as a barrier to such efficient investment. 

An excellent but very basic example is a Business Z, located in Town A, on real Property X. Real Property X is not suitable to Business Z, however, the owner of Business Z inherited the property from his parents, so it was available and feasible. However, due to the unsuitability of real Property X for Business Z, it has not realized great success in Town A, but is still valuable real property due to its size. There is another property in Town A, real Property Y, that is quite suited to Business Z and likely to significantly increase the foot traffic and quality of experience for customers of Business Z. It is much smaller than Property X, but similar in value due to its location. Business Z generally has three options, 1.) Find a means of financing and purchasing Property Y, while maintaining property X, which may not be economically feasible, 2.) Sell Property X, pay the taxes on any gain, then use the proceeds to help pay for purchasing Property Y and then obtaining financing for the rest, or 3.) Engage in a 1031 transaction. With 1031, business Z can simply swap X for Y, without paying taxes, and without having to concern himself or herself with financing because this is an exchange and not a sale and purchase. Business Z moves to Property Y and thrives. 

This important provision has likely been a significant factor in our economy’s recovery and without question, has been a key part of the real estate industry‘s recovery. Recently this important provision has come under attack from elected officials on both sides of the aisle, in an attempt to foot the bills being generated by the same elected officials, with very little consideration for the practical effect of such a change. 

In the next installment of this two-part article, I will address the argument that IRC Section 1031 represents a loophole, and the present efforts to significantly change or completely abandon IRC 1031 altogether.

 

Topics:  IRC, IRS, Section 1031, Tax Reform

Published In: Elections & Politics Updates, Residential Real Estate Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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