Like-Kind Exchanges have been used in real estate transactions since their inception in 1921. While there’s opposition regarding these exchanges by those who see these as tax loopholes for the super rich, there are several good reasons as to why Like-Kind (1031) exchanges have remained a sound tax policy for close to 100 years.
Since repealing 1031 Exchanges has been a major topic of discussion in this year’s election, we thought it would be important to share more about this policy and how repealing it could negatively impact real estate entrepreneurs.
What are Like-Kind Exchanges?
While it’s referred to several ways, Like-Kind or 1031 Exchanges, were named after the Internal Revenue Service Code Section 1031. Exchanges allow real estate entrepreneurs to defer capital gains taxes on investments if the proceeds are reinvested in another property of equal or greater value.
There are restrictions real estate entrepreneurs must meet, however, which limits its use. To qualify, properties must be “like-kind” such as single family or multi-unit buildings. Real estate entrepreneurs cannot use an exchange on a personal residence or on personal property, and they must complete both transactions within a six-month period.
When real estate entrepreneurs can use an exchange and not have the immediate tax burden like with ordinary sales, they have more capital to spend. By nature of the policy restrictions, real estate entrepreneurs must match the value or upgrade the second property which in turn raises the tax liability due when it is finally disposed of through an ordinary, taxable sale.
Without exchanges, real estate entrepreneurs will be required to pay capital gains taxes when a sale occurs. This would reduce the amount of capital a real estate entrepreneur has to fund their next purchase. With less money to spend, we can expect transactions to be at lower values than if the tax was deferred.
Elimination of Like-Kind Exchanges will not raise more revenue.
Studies have proven that repealing Like-Kind Exchanges will not equate to the theoretical surplus of funds that some parties believe it would. (Some parties wish to repeal 1031 Like-Kind Exchanges in order to allocate the surplus of funds that will draw towards a proposed Care Plan.)
According to a 2015 study, The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate by Professors David C. Ling and Milena Petrova from Universities of Florida and Syracuse, respectively, eliminating exchanges will not raise more revenue. In fact, we should expect less current tax revenue.
Why?
Smart real estate entrepreneurs will no longer make as many transactions as they do now. Instead, they will begin holding onto properties longer, and with fewer transactions, there will be less tax revenue, not to mention a reduction in other sectors impacting the US economy.
Like-Kind Exchanges are important to efficient operations of thousands of businesses in our country.
Contrary to what some people believe, Like-Kind Exchanges have a significant positive impact on many industries. However, opponents seem to forget who would be impacted the most if this policy were repealed.
Real estate transactions involve numerous people in the real estate sector, as well as within the community. According to the Ling-Petrova study, exchanges encourage real estate entrepreneurs to seek the best use of real estate which often leads to property improvements, employing contractors and laborers, increasing purchases of building materials and supplies, all of which stimulate the local economy.
It is a domino effect at its simplest form.
The transaction may begin with brokers and agents, but it involves appraisers, inspectors, mortgage lenders, title companies, insurers, attorneys and many more. Building improvements often lead to higher local taxes as well, further helping the community.
In the long run, repealing Like-Kind Exchanges will decrease demand for these positions and increase unemployment.
Real estate entrepreneurs don’t avoid taxes, they defer taxes with Like-Kind Exchanges.
Adversaries to Like-Kind Exchanges believe that real estate entrepreneurs will never pay taxes on real estate. But this could not be further from the truth.
For starters, real estate entrepreneurs can only defer capital gains taxes. They cannot avoid or eliminate taxes altogether. When the property eventually sells via an ordinary sale and not utilizing an exchange, tax will be due.
Opponents argue that real estate entrepreneurs rollover properties indefinitely, thus being the never-ending loophole opponents of this policy want to close. But the Ling-Petrova study contradicts the myth these adversaries support.
The study shows that 88% of properties acquired in an exchange were sold through a taxable sale, and not a subsequent exchange.
In fact, when an exchange property is sold through an ordinary sale, the tax liability is higher than if the real estate entrepreneurs didn’t use an exchange at all.
Like-Kind Exchanges benefits all real estate entrepreneurs—not just the wealthy ones.
Despite what you may have heard, you do not need to be super rich to benefit from Like-Kind Exchanges. As a matter of fact, real estate entrepreneurs and individuals alike have utilized exchanges in real estate transactions for years.
Middle-class Americans who purchase a rental property to support their income and build wealth for retirement are a large portion of the real estate entrepreneurs who would be impacted if this policy were repealed.
Small business owners have historically relied on exchanges when making decisions regarding their operations and facility. Having the ability to defer tax provides more cash flow enabling them to improve efficiencies to grow their business. And with growth, comes added jobs.
Without Like-Kind Exchanges, real estate entrepreneurs have less incentive to invest in real estate.
Repealing Like-Kind Exchanges will have a negative impact on the economy.
Without the ability to defer taxes, real estate entrepreneurs will pull back. We will see fewer transactions which will ultimately affect the workforce.
In the best of economic times, repealing exchanges would be challenged due to the negative impact on so many industries and professions. Jobs would be lost. Unemployment would rise.
But in today’s post-coronavirus recession, repealing exchanges would be a horrible idea, one that would devastate our economy beyond repair.
Simply put, Like-Kind Exchanges are good for the US economy.
As real estate entrepreneurs ourselves, RealEstateInvestor.com is not in favor of anything that eliminates 1031 Like-Kind Exchanges as this would negatively impact the amazing real estate entrepreneurs whom we have the privilege to serve.
Like-Kind Exchanges encourage investment and transactional activity which creates and retains jobs here in the US. By supporting Like-Kind Exchanges, we are supporting America and reinvesting in our future.
We encourage our members to do their own research on policies that threaten to repeal 1031 Like-Kind exchanges so that they can better understand where they stand on policies such as this one that is up for debate in 2020.
Resources Used:
https://www.financialpoise.com/like-kind-exchanges-4-myths-debunked/
https://1031x.com/biden-to-end-1031-like-kind-exchanges/
https://www.1031taxreform.com/wp-content/uploads/FEA-ltr-to-Biden-Campaign-5-5-20-FINAL.pdf
*We Are Not Affiliated With Any Of The Above Websites. We Simply Used Data From These Resources In Research For This Article Only.
