Real Property Like-kind Exchanges Since 1921, the Internal Revenue Code has recognized that the exchange of one property held for investment or business use for another property of a like-kind results in no change in the economic position of the taxpayer and therefore should not result in the imposition of tax. This concept is codified today in section 1031 of the Internal Revenue Code with respect to the exchange of real and personal property, and it is one of many nonrecognition provisions in the Code that provide for deferral of gains. The Obama Administration’s fiscal year 2015 budget targets section 1031 by substantially repealing the provision with respect to real property by limiting the amount of gain that may be deferred to $1 million annually. This proposal could have a significant negative impact on the real estate sector with real implications for the broader economy. Background The original like-kind exchange rule goes all the way back to the Revenue Act of 1921 when Congress created section 202(c), which allowed investors to exchange securities and property that did not have a “readily realized market value.” This rather broad rule was eliminated in 1924 and replaced with section 112(b) in the Revenue Act of 1928, which permitted the deferral of gain on the like-kind exchange of similar property. With limited exceptions, generally related to narrowing the provision, Congress has largely left the like-kind rule unchanged since 1928.1 Section 1031 permits taxpayers to exchange assets used for investment or business purposes for other like-kind assets without the recognition of gain. This applies to both real property and personal property. The tax on such gain is deferred and in return the taxpayer carries over the basis of the original property to the new property, losing the ability to take depreciation at the higher exchange value. Gain is immediately recognized to the extent cash is received as part of the like-kind exchange, and the taxes paid on such gain serve to increase the newly-acquired property’s basis. The like-kind exchange rules permit flexibility in the exchange by giving the owner up to 180 days before or after the disposition of the original property to find replacement property, typically accomplished through the use of an intermediary. Policy Rationale The like-kind exchange rules are based on the concept that when one property is exchanged for another property there is no receipt of cash that gives the owner the ability to pay taxes on any unrealized gain. The deferral is limited and does not extend to investments that are liquid and readily convertible to cash, such as stocks, bonds, notes, securities, and inventory. The notion that section 1031 seeks to distinguish between illiquid assets, such as real estate, and readily tradable investment interests is a long-standing principle underlying the provision.2 The person who exchanges one 1 The rule was renumbered as section 1031 in the Internal Revenue Code of 1954. The Deficit Reduction Act of 1984 clarified rules governing the application of section 1031 in non-simultaneous exchanges and provided that the deferral of gain under section 1031 is not available with respect to exchanges of partnership interests. The Taxpayer Relief Act of 1997 created a special rule which provides that U.S. real property and non-U.S. real property are not property of a like-kind. Congress has also limited the availability of other tax benefits if the property was acquired in a like-kind exchange. See I.R.C. § 121(d)(10). 2 See Joint Committee on Taxation, General Explanation of the Revenue Provisions of the Deficit Reduction Act of 1984, at 245 (“Congress believed that, at least under current conditions, partnership interests typically property for another property of like-kind has not really changed his economic position; he held one property and exchanged it for another property. The taxpayer, having exchanged one property for another property of like-kind is in a nearly identical position to the holder of an asset that has appreciated or depreciated in value, but who has not yet exited the investment. Under the tax code, the mere change in value of an asset, without realization of the gain or loss, does not generally trigger a taxable event. In such situations, the proper tax treatment is to defer recognition of any gain and maintain in the new property the same basis as existed in the exchanged property. This is similar in concept to other non-recognition, tax deferral provisions in the tax code that reflect basic, broadly accepted policies about the nature of gain realization, applicable, for example, when property is exchanged for stock under section 351, when property is exchanged for an interest in a partnership under section 721, and when stock is exchanged for stock or property under section 361 pursuant to a corporate reorganization. Economic and Social Benefits of Real Property Like-Kind Exchanges The like-kind exchange rules under section 1031 are a basic tool that lubricates the smooth functioning of the real estate industry in the United States today. Allowing capital to flow more freely among investments facilitates commerce, and supports economic growth and job creation. Real estate owners use section 1031 to efficiently retain and allocate capital to its most productive uses. It enables owners to reposition portfolios, exchange peripheral assets for core assets, realign property by geography or real estate sector to improve operating efficiencies, and manage risk. By increasing the frequency of property transactions, it facilitates a more dynamic real estate sector that supports more reinvestment in real estate and a higher level of construction activity. Moreover, the ability to defer gain through a like-kind exchange leads to lower levels of leverage and debt in real estate transactions. The buyer of replacement property in a like-kind exchange is more likely to have a higher down payment because drawing out the cash proceeds from exchange sales results in immediate tax liability. According to the commercial real estate information company CoStar, from 1999 to 2005, tax- deferred exchanges represented approximately 32 percent of apartment building transactions, and 20 percent of office building transactions in the largest 15 markets. In some markets, such as San Diego and San Francisco, the majority of commercial real estate transactions in that period involved the use of like-kind exchanges. While it is quite possible that many of those transactions would have occurred without section 1031, it is also likely that many would not have occurred with the result that there would have been a less dynamic real estate market and slower economic growth. The existence of the like kind exchange rules also positively affects local government budgets since more frequent turnover of real estate generates significant property transfer and recording fees to fund government operations. Finally, section 1031 is often a critically important means of facilitating conservation real estate transactions involving important open spaces and/or significant environmentally sensitive properties that may be exchanged for other privately held like-kind property, such as adjacent farmland or ranchland. These types of transactions help to achieve the public benefit of securing the protection of environmentally significant land and open space for the future while at the same time enabling private landowners to preserve capital for expansion or diversification of existing operations, retirement, or other needs. represent investment interests similar to those items previously excluded from like-kind treatment and should therefore also be excluded from such treatment.”). - 2 - .