The Internal Revenue Code section 1031 exchange, better known as “1031s” or “equivalent exchange”, is a nearly century-old tax deferral mechanism that can be abolished or curtailed under several tax reform proposals debated in Congress.
Using a 1031 exchange is simply a matter of timing and taxes: taxes are postponed to make important investments in the meantime. In particular, a taxpayer can defer recognition of capital gains and the associated federal income tax liability when exchanging certain types of property. This can include real estate, heavy equipment, nature reserve, and other investments.
It is important that the stock exchange provides for a tax deferral – it does not waive the tax, but postpones the tax due until the final ruling in order to encourage further investments.
Section 1031 of the Code states: “In the exchange of property that is held for productive commercial or business purposes or for investments, no gain or loss may be recorded if this property is exchanged exclusively for property of the same type for which it is held is said to be productive use in trade or industry or for investment. ”The purpose of the 1031 stock exchanges is to ensure continued reinvestment and the resulting growth of the private sector.
For example, when an asset such as a medical device is sold, federal and state capital gains, along with refunded depreciation taxes, can exceed 40 percent of the sale price. Instead of paying tax on the sale, the seller can postpone it by reinvesting the entire sales proceeds through a similar exchange. 1031 thus acts as a reliable investment catalyst that would otherwise be lost when selling an investment.
This exchange helps to create an economic incentive for our country. According to a 2015 study by auditing firm Ernst & Young LLP (EY) entitled “Economic Impact of Repealing Like-Kind Exchange Rules,” removing this incentive would cost our nation more than $ 8 billion annually. EY also reports that investment levels are expected to increase by $ 7 billion across the country.
It is important that these numbers are minus the tax revenue related to the termination of tax deferrals for similar currencies. In other words, with the repeal of Section 1031, the government can get immediate funding, but the economy suffers.
The EY study also found that removing the Section 1031 treatment of qualifying like exchanges would increase the cost of capital even at lower tax rates. It would also discourage business investment, which would obviously be detrimental to the overall economy. In addition, the abolition of 1,031 similar exchanges would expose individuals and companies to a higher tax burden, which would lead to longer holding periods, a greater dependence on external financing and a less productive use of capital in the economy.
Another misconception about the Section 1031 exchanges is that they are tax “loopholes” for the wealthy. Section 1031’s predecessor was incorporated into the original U.S. tax law because it made sense: it created a deferred process for exchanging (not selling) one valuable property for another without collecting federal tax. Again, taxes are paid as soon as an investment is completed; the money is used in the economy and generates economic activity during the lag.
Regarding real estate, a 2015 study by David Ling, Ph.D., a professor in the University of Florida’s Warrington College of Business and Assistant Professor of Finance Milena Petrova, Ph.D., at Syracuse University, came to that Conclusion that the prices for commercial real estate in markets with moderate taxes between 8 and 17 percent and in high-tax countries and markets between 22 and 27 percent would fall if the tax deferral according to § 1031 were reduced or completely eliminated.
In addition, according to the study, rental prices in these markets would rise significantly, in heavily taxed markets by as much as 38 percent.
§ 1031 similar exchanges are anything but a loophole for tax avoidance; they are an almost pure form of economic development, a provision of the tax code that serves to increase investment and stimulate economic activity. From the point of view of the tax collector, a similar exchange ultimately leads to a loss of depreciation and an increase in local sales and property taxes. An interim redirection of tax revenue into increased construction activity and the creation of countless jobs is not a disadvantage.
This country wants to expand economic activity and generate growth. Section 1031 is an important part of our tax code that is misunderstood and needs to be protected. Even if a well thought-out tax reform would be welcomed by our association and our membership, we should not throw the baby out with the bathwater.
Section 1031 is a fair and thoughtful means of maintaining private sector investment, resulting in significant economic incentives. Tax simplifications and lower tax rates are certainly to be welcomed, but this goal can be achieved without destroying aspects of the Code that are actually helpful, fair and valuable, such as: B. Section 1031.
John Harrison is the executive director and CEO of ADISA, the Alternative Direct Investment and Securities Association, the nation’s largest trading association serving the non-traded alternative investment space.
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