In the interests of full disclosure, I have what one of my daughters calls “ancillary business”, in which I facilitate the real estate exchange under “Section 1031”.
I suppose that makes me biased towards things like that. It’s just a sideline though, so I’m not dependent on it.
These exchanges allow an investor to defer paying taxes on profits. It is said that Congress is targeting the same exchange provisions. To be fair, that word has been on the street for a long time and nothing came of it.
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This is one that I just don’t understand. I know the government needs money, and I’ve even discussed a few ways they might think about finding some change. There is nothing unique about real estate exchanges. Setting it up as a sales target behaves as it is.
Tax law states that when an asset is sold or exchanged, a gain or loss is “realized”. If it is a win, it needs to be “captured” at this time, unless an exemption clause can be found.
The law contains several exemptions to protect a taxpayer from recording a realized gain. They all operate on a single principle – no profit if the taxpayer has simply continued his investment in an alternative form. The shape changed, the substance didn’t.
For example, let’s say you own a business. Things are going well, but an attorney is warning you that you are taking too much personal risk and need a separate entity to house the business.
They are all there. You will exchange ownership of $ 1 million worth of corporate assets with a tax base of $ 400,000 for $ 1 million worth of corporate shares. You have a realized gain of $ 600,000 on an exchange.
The IRS visits your office and says in a gritty voice from an old gangster movie, “This is good business you have. It would be a shame if something happened. ” Indeed. Sounds like someone needs relief.
In accordance with Section 351 of the Tax Act, no profit is recognized when ownership is transferred to a company solely for shares. Why? Because the taxpayer simply continued the substance of the business in an alternative (corporate) form.
The same relief is possible when you attract a partner to this business. You are exchanging your company for an interest in a partnership. Same realized profit. According to Section 721 of the Tax Act, you can avoid recording profits. Same reason – you continued the content of the investment in an alternative form.
Twenty years ago two company sizes merged, Phillips Petroleum and Conoco. The shareholders of each company gave shares for shares of the new ConocoPhillips.
Many shareholders had a realized gain on this share swap. You did not receive any cash. According to Section 368 of the Tax Act, this exchange was tax-free as the former Phillips or Conoco shareholders continued the content of their investment in an alternative form.
Three tax breaks. Same principle. Same result. There are more. Section 1031 is one. You can use it to exchange properties that are held for investment or business purposes for other properties that are held for investment or business purposes. The content of the investment remains in a different form.
Section 1031 has nothing special. It is part of a package of tax relief provisions that serve the same tax policy purpose. But it attracts more attention than the others. It shouldn’t.
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 investments.
Lock in means that an owner can decide to cancel an investment if they learn that a sale reduces the available assets by the tax paid on the profit.
A $ 1 million investment can turn into $ 900,000 after taxes. A “better” investment of $ 900,000 in another asset may be less attractive than continuing your current investment of $ 1 million. In this case, the owner feels bound to the current investment.
According to § 1031, real estate may only continue trading tax-free for investment reasons. 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.