The 1031 Exchange Blog

1031 Tax Free Exchange: Worthy Federal Tax Expenditure?

Posted by Andy Gustafson on Tue, Feb 08, 2011

The 1031 tax free exchange tax expenditure review starts on page 425 of the recently released 1,000 page report by The Congressional Research Service called "Tax Expenditures: Compendium of Background Material on Individual Provisions" for the Senate Budget Committee. Chairman Senator Conrad states in his introductory comments "There are over 200 separate tax expenditures in current law, costing the Treasury more than $1 trillion each year. Given the nation's unsustainable long-term  budget outlook, all tax expenditures and spending deserve increased scrutiny."


1031 Tax Free Exchange1031 Tax Free Exchange Deferral of Gain

The report recognizes the 1031 exchange as a tax free exchange described when "no gain or loss is recognized on the exchange and therefore no tax is paid at the time of the exchange" given the old or relinquished and replaced property are like-kind, held for use in a business or investment. This is different than the taxable event that occurs when property is sold. Consequently, the tax is postponed and considered a tax expenditure.

The report states the courts have loosely interpreted the IRS 1031 code granting 1031 exchanges of like-kind property but of different quality and use. This allows the medical office building owner to exchange for oil and gas interests or a thirty year timberland lease effectively deferring tax on the appreciated gain. Highly valued collectibles such as antique cars and violins can be exchanged for like-kind personal property given the value is equal to or greater than the property sold. The difference is taxable.

1031 Exchange Rationale

The accepted rationale for tax free exchanges is that the 1031 exchange represents a continuation of the investment from the old to the new property. The tax obligation is postponed providing an incentive to acquire new equipment, land, commercial and single family rental properties. Furthermore, the IRS 1031 code allows the Exchangor, independent of income tax bracket to easily and inexpensively replace one asset for another without the immediate tax consequences. 1031 exchanges do not discriminate age or ethnicity. They are initiated by the hourly worker, retired, corporation and non resident alien. The qualified intermediaries who accommodate the 1031 exchange provide an economical record keeping neighborhood watch program implementing 1031 exchanges for the benefit of their clients in accordance with IRS regulations.

Conclusion

Since 1921, the IRS 1031 code has allowed real and personal property owners to replace properties for reasons of:

  • cash flow;
  • relocation;
  • consolidation;
  • diversification;
  • appreciation;
  • depreciation;
  • low basis to high basis;
  • labor intensity.

Each of the above freedom of choices are not tax induced and accomplished without paying a Federal and State (if applicable) capital gains tax. The tax is deferred and triggered when the replacement property closes or postponed with another tax deferred exchange. The tax is ultimately paid unless the property is gifted to their heirs or a charity. The 1031 code enhances the constant turnover of property. Without the 1031 tax free exchange, properties will be held longer resulting in fewer sales and less demand for replacement property.

Do you think 1031 tax free exchanges are worthy of the Federal tax expenditure? I would enjoy your input.

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Tags: tax free exchange, capital gains tax, 1031

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