In the interest of full disclosure, I have what one of my daughters calls a “side hustle” in which I facilitate “Section 1031” real estate exchanges.
I suppose this makes me biased in favor of such things. However, it’s just a side hustle so I am not dependent on it.
These exchanges allow an investor to defer paying taxes on gains. Word is that Congress has its sights on the like-kind exchange provisions. To be fair, this word has been on the street for a long time and nothing has come of it.
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This is one that I just don’t get. I know the feds need money, and I’ve even discussed a few ways that they might think about finding some spare change. There is nothing unique about real estate like-kind exchanges. Setting them up as a revenue target acts like there is.
The tax law says that when an asset is either sold or exchanged, a gain or loss has been “realized.” If a gain, it must be currently “recognized” unless a relief provision can be found.
The law has several relief provisions to protect a taxpayer from recognizing a realized gain. They all operate on a single principle – no gain if the taxpayer has simply continued his investment in an alternative form. The form changed, the substance did not.
Let’s say that you operate a business as a proprietor. Things are going well but an attorney advises you that you are taking too much personal risk and need a separate entity to house the business.
You are all in. You exchange ownership of business assets worth $1 million with a tax basis of $400,000 for $1 million of corporate stock. You have a $600,000 realized gain from an exchange.
The IRS visits your office and, in a gravelly voice from an old gangster movie, says “that’s a nice business you have. It’d be a shame should something happen to it.” Indeed. Sounds like somebody needs some relief.
Section 351 of the tax law says no gain is recognized when property is transferred to a corporation solely for stock. Why? Because the taxpayer has simply continued the substance of the business in an alternative (corporate) form.
The same relief is possible if you choose to bring in a partner to this business. You exchange your business for an interest in a partnership. Same realized gain. Section 721 of the tax law allows you to avoid recognizing any gain. Same reason – you continued the substance of the investment in an alternative form.
Twenty years ago, two corporate behemoths, Phillips Petroleum and Conoco, merged. Shareholders of each company surrendered shares for shares in the new ConocoPhillips.
Many shareholders had a realized gain on this share swap. They received no cash. Section 368 of the tax law allowed this exchange to be tax-free because the former Phillips or Conoco shareholders continued the substance of their investment in an alternative form.
Three tax relief provisions. Same principle. Same result. There are more. Section 1031 is one. It allows you to exchange real estate held for investment or business use for other real estate to be held for investment or business use. The substance of the investment continues in a different form.
There is nothing special about Section 1031. It is one of a package of tax relief provisions serving the same tax policy purpose. But it draws more attention than the others. It should not.
There is an argument that Section 1031 serves a purpose broader than the others I mentioned. It mitigates the “lock in” effect and creates liquidity for real estate investment.
Lock in means that an owner may decide to ride out an investment when he learns that a sale will reduce available assets by the tax paid on the gain.
A $1 million investment may turn into $900,000 after taxes. A “better” $900,000 investment in another asset may be less attractive than continuing the $1 million current investment. If so, the owner feels locked in to the current investment.
Section 1031 allows real estate to keep trading based solely for investment reasons, free of tax penalty. Yes, it’s a tax break, but it comes from a good family.
James R. Hamill is the Director of Tax Practice at Reynolds, Hix & Co. in Albuquerque.