By Billie Sue Records
In the coming months, we will likely be hearing a lot of talk from Washington about federal tax reform and closing loopholes. Simplifying and making federal tax laws fair are admirable goals. Care must be taken that the results also benefit our nation’s economic structure.
Of particular concern are suggestions from a few lawmakers that “like-kind exchanges,” or “1031 exchanges,” should be discontinued. The exchanges get their name from the Internal Revenue Code Section 1031.
These exchanges are mechanisms used by companies and investors to temporarily defer paying federal capital gains taxes on such things as the sale of farm equipment, aircraft, intellectual property and real estate.
The 1031 Tax Code was created in 1921 and embodies a centuries-old concept of horse swapping. Trade a horse for a horse, or in today’s world, business property for like-kind business property.
To grasp the concept, consider the common exchange involved in the purchase of a single-family rental. The buyer has two rentals. She sells both to purchase a newer single-family rental that will bring in higher rent values. The seller sells both relinquished properties and purchases a higher value rental.
When we are talking about using 1031 exchanges to “swap” business property or equipment, it’s more complicated and regulated. It also requires the assistance of a “qualified intermediary.”
In a 1031 exchange, an investor places the proceeds from his relinquished property — for example, a commercial building — with his “qualified intermediary,” while he searches for “like-kind property” to purchase. When the transaction is completed, the investor postpones the capital gains tax liability on the sale of the relinquished property.
These taxes are postponed or deferred, as long as the “new property” is held by the investor for a certain period of time. More often, taxes owed will be paid when the “new property” eventually is sold, unless another 1031 exchange again is used to sell the property and acquire “like-kind” replacement property.
Across every industry, 1031 exchanges are used in a wide variety of transactions. As an example, when medical equipment is sold, federal and state capital gains, combined with recaptured depreciation taxes, could equal 25 percent to 40 percent of the gain. Rather than paying taxes on the sale, with a 1031 exchange, the seller can defer paying taxes by reinvesting the proceeds in the purchase of new, like-kind equipment.
This deferred payment of capital gains taxes, which has long been regarded as a critical incentive for owners to grow their businesses and invest in the U.S., is a proven economic stimulator. This puts the dollars back into the community, creating jobs, increasing taxes, etc.
A 2015 study by the national accounting firm Ernst & Young concluded removing the stimulus would cost the nation around $8 billion. Investment levels nationwide would likely decline by $7 billion annually, while national income would fall by $1.4 billion annually.
Using a 1031 exchange is simply a matter of timing. Taxes are delayed in order to make short- or long-term investments, relocate businesses, grow businesses, or change real estate portfolios. It does not “forgive” payment of taxes.
Before growing, or reinvesting in your business, talk to an accountant and attorney to determine if a 1031 exchange will be beneficial.
Billie Sue Records is senior vice president 1031 exchange manager at Bakersfield-based Mission Bank.