The commercial real estate industry has sounded the alarm with a simple message to Congress: Hands off the 1031 exchange.
Lobbyists from Washington joined San Diego-area brokers and companies that depend on the 1031 exchange at a breakfast Tuesday sponsored by Commercial Real Estate Alliance of San Diego division of the San Diego Association of Realtors at the Handlery Hotel.
Internal Revenue Code 1031 allows an investor to exchange a business or investment asset for another and to defer all capital gains taxes.
“If the 1031 exchange were eliminated, it would be huge,” warned Curtis Gabhart, CRASD’s president.
“Let everyone know that we take this threat very seriously,” said John Wunderlich, Investment Property Exchange Services’ president whose business could evaporate if 1031 exchanges were eliminated.
As Investment Property Exchange notes, the 1031 exchange is being threatened on three fronts.
The House Ways and Means Committee calls for repeal of the 1031 exchange effective Jan. 1, 2015.
The Senate Finance Committee has proposed to repeal 1031 as well, “but leaves the door open for real property and intangible property exchanges. It also suggests a potential modification of the like-kind standard to the narrower section 1033 standard requiring that properties be similar in service or use.”
The third proposal would limit real property exchanges to $1 million.
Put simply, tax reform, which the Republican Congress has been pushing, could include eliminating the 1031 exchange.
Evan Liddiard, National Association of Realtors senior policy lobbyist, noted that the 1031 is hardly new and, in fact, dates back to 1924.
Both Derrick Evens, UT-San Diego‘s real estate director, and Liddiard said that people often have a common misconception about the 1031.
“What many people don’t understand is this is not a tax-free exchange, it is tax-deferred,” Liddiard said.
Liddiard added that with Republicans bent on reforming the tax code and some Democrats (former U.S. Sen. Max Baucus tried to do away with the 1031) viewing the vehicle as an unfair perk, the 1031 has been slammed by both parties.
Liddiard said 1031 exchanges are also simply misunderstood in other ways. For example, contrary to popular belief, “it isn’t a tax loophole.”
Liddiard said there is no greater false perception by a joint Congressional Committee on Taxation than believing that eliminating the 1031 would save $100 billion in five years.
He countered that the loss to the economy would actually be hundreds of billions of dollars more as sellers and transactions disappeared.
While the tax is deferred, there are all kinds of benefits to exchanges, some say.
Liddiard used the example of a woman named Joan who owns a fourplex worth $300,000 that she bought 20 years ago for $150,000. Joan has taken depreciation deductions of $100,000, leaving her with a basis of $50,000, which is the cost of the land.
If Joan were to sell her property, her capital gain would be $250,000. If she were to exchange it with a property worth $300,000, her capital gain impact would be zero.
Liddiard noted that Joan’s basis in the new property would still be $50,000 and that future gains would be assessed when she sells, and that there would be no depreciation on the new property.
Evens said he sees pressure building against the repeal of the 1031.
“We are talking here today so that we will create a groundswell against the proposed changes. … If no one cries wolf, who’s going to know what’s coming?” Evens said.
Liddiard said the tax deferral is necessary, especially in common but complicated four-way transactions.
He said his former boss, Utah Sen. Orrin Hatch, had once voted against a tax reform bill because he was worried what it might do to the 1031 exchange.
“We need to show members of Congress that if they do this, it will only hurt the economy,” Liddiard said.
Chris Pascale of CBRE said San Diegans and other Californians need only look as far as the battles against raising the linkage fee and against the split-roll tax to demonstrate how successful such campaigns can be.
Pascale said the 1031 exchange allows people to keep their wealth by eliminating the need for excess transactions.
“This would create more expenses. The tenant would have to pay more rent and John’s company (Investment Property Exchange Services) would be out of business,” Pascale said. “It would be a really crappy idea.”
Suzanne Goldstein Baker, who also works at Investment Property Exchange, said that in addition to the impact on her business, “the 1031 is so intertwined in the U.S. economy, I can’t imagine what would happen if it weren’t there.”