Viewpoint: Beware changes in 'like-kind' transactions under proposed federal tax reform
Rarely do the interests of small businesses owners and a broad range of local entrepreneurs agree with almost a century of federal income tax policy – especially when it results in billions of dollars in taxes being paid.
But luckily for the economy, they do.
The trouble is, this powerful economic driver is now in real danger as Congress and the Trump Administration grapple with the twin dilemmas of tax reform and a threadbare federal budget that would put such long-term investments and incentives at risk.
As we inch ever-closer to seeing the draft legislation from the House and the Senate, concern continues to mount with respect to the future of this important economic contributor. And while this tool may lack the broad recognition afforded other important tax issues – from mortgage interest deduction to credit for state and local taxes – its power and impact are nonetheless critical, especially since the results are felt directly in local communities across the country.
Simplification of the tax code and the elimination of unfair loopholes are noble intentions indeed, but mistaking a positive revenue and economic driver for a negative, and putting billions of dollars of tax revenue and sustained economic growth in the crosshairs is unwise, especially as small business owners stand to be hit the hardest.
For more than 90 years, like-kind exchanges (under Section 1031 of the Internal Revenue Code) have been a key enabler for small businesses and investors to expand their businesses by exchanging rental or business-use real estate, for example, for other rental or business-use real estate without an immediate tax penalty.
Just like a 401(k) or IRA where the tax payment on the gain is deferred until it’s withdrawn, like-kind exchanges make it possible for small business owners to grow and exchange their real estate as markets change and then pay the full amount of the resulting tax burden when the property is ultimately sold rather than exchanged. To state the obvious, both buyer and seller have the opportunity to gain through such a transaction.
For example, a landlord who sells a four-unit building, via a like-kind exchange, for an eight-unit building incrementally grows the business, while deferring the taxes. Once the landlord sells the second building instead of exchanging it, the total amount of taxes owed on the gain are paid. This too can be the case for owners who – as the result of a decline in their health or a need to retire – are no longer interested or able to maintain a property, an event that could negatively impact all of those who live or work there. In commercial property exchanges, about 88 percent of replacement properties acquired in a like-kind exchange are eventually disposed of in a taxable sale – where the tax is eventually paid.
And it’s not just real estate that benefit, heavy equipment companies are equally in the need to the growth potential that like-kind exchanges enable. A business that sells an old tractor or bulldozer, via a 1031 exchange, for a new model (which happens every 2-3 years, on average, given the wear and tear of heavy construction) incrementally grows the company’s business, while deferring the taxes. Once the owner sells the second piece of machinery instead of exchanging it, the total amount of taxes owed on the gain are paid. And given that some of the largest John Deere or Caterpillarconstruction equipment can cost close to $1 million, like-kind exchanges often make the difference between a successful and a postponed purchase.
Today, the capital requirements – and the need to keep up with technology and innovation – that small business owners face is enormous, and growing. Without the ability to rely on a like-kind exchange, many owners will, sadly, allow properties to fall into disrepair because the cost of sale is too high or simply put off new investments into business assets.
Dilapidated apartment buildings, crumbling farms, and aging equipment are destined to increase if their owners are faced with a sale where an immediate tax payment robs them of their ability to fully reinvest and grow for the long-term. With a 1031 exchange, however, a new owner will emerge to improve the property (hiring contractors and others in the process) and stimulate the economy as the prior owner transitions.
Moreover, during the post-2008 economic downturn, like-kind exchanges made it possible for real estate transactions to continue to occur. But for this tool, that market would have frozen to an even greater degree, just at the time when the economy could least afford it.
A 2015 Ernst & Young study found that the failure to keep like-kind exchanges intact would result in the contraction in overall U.S. GDP of approximately $8.1 billion annually. The loss to GDP over a 10-year period was predicted to be $61–$131 billion, depending on how that revenue is ultimately replaced.
As the backbone of the nation’s economy, especially at the local level, we know what it takes for small businesses to thrive, and how – contrary to popular perception – government can help. The opposite of a Washington-run program, like-kind exchanges wisely replace mandates from bureaucrats with locally-focused and customized marketplace solutions.
For Congress and the White House the next step is clear and obvious – like-kind exchanges work just as they always have. Putting such a continuous circle of economic stimulus and liquidity at risk threatens adverse consequences, with far too little offered in return.