With Congress debating the merits of like-kind exchanges, it’s important to correct misconceptions surrounding the program
The latest news regarding 1031 is that the Senate passed an amendment via voice vote during the budget reconciliation process this month recommending Section 1031 of the tax code not be changed. While this is certainly encouraging news because it means lawmakers are recommending 1031 remain as it is, the vote is not binding and does not amend the law.
We know the Biden Administration has its sights set on Section 1031, with many seeing it as a symbol of tax evasion by the wealthy. Part of the problem is that there are many misconceptions about the program because of how it’s covered in the media, which can be frustrating to those in the industry.
In order to combat misinformation, we’d like to address some of the myths surrounding 1031, how it is used, who uses it, and its impact on taxes and economic recovery. That way, the public can better understand what will be lost if it is changed. Here are some of the most common 1031 myths and what they get wrong.
Myth #1: “1031 is a Loophole for the Rich to Avoid Paying Taxes”
The first thing readers should know is that Section 1031 isn’t new. Congress first codified like-kind exchanges in 1921, not long after the enactment of income tax. But that doesn’t mean it’s an arcane rule, either. Over the years, the regulations have been changed many times, including as recently as 2017. Now, exchanges are only allowed for real property, which cuts down on categories which are perceived to only benefit the wealthy such as such as fine art, collectibles and private aircraft. Real property, which includes real estate, also supports important social and environmental objectives, such as land conservation and the preservation of family-owned farms.
A related myth is the idea that 1031 is a secret, or isn’t widely used. In fact, 1031 exchanges represent a large portion of real estate transactions. Research by Professors David Ling and Milena Petrova estimates that 6% of commercial real estate transactions involve a like-kind exchange, and a survey of realtors estimated the market value of these properties to be 39% of the market. 1031 isn’t a shadowy method, and isn’t a loophole that allows people to get out of paying what they owe. It’s an important element of the real-estate ecosystem that has benefits that go well beyond tax deferral.
Myth #2: “1031 Exchanges Deprive the Government of Tax Revenue”
Investors are not avoiding taxes by participating in exchanges – they’re deferring payment of those taxes. Doing so allows them to take the capital gains from the property sale and reinvest them in a replacement property. If the value of the replacement property grows and it’s eventually sold at a profit, there will be more wealth to be taxed, meaning the amount collected through taxes would be higher.
Ling and Petrova estimate the taxes paid from an exchange followed by a sale are 19% higher than from two ordinary sales without a 1031 exchange. By allowing investors to defer taxes, we create more wealth, which creates more tax revenues.
Myth #3: “1031 Exchange is Only for the Rich”
Despite what you may have heard, one does not have to be wealthy to take advantage of 1031. In fact, the barrier to participation is quite low, thanks to the use of Delaware Statutory Trusts, which allow investors to diversify real property investments and take part in like-kind exchanges without being a sole owner. And since mortgaged property does qualify under Section 1031, this is a great way to build wealth over time.
Like-kind exchanges have become a critical sources of retirement security for those who don’t have traditional retirement accounts. This can include the self-employed or small business owners who lack employer-provided pension plans, allowing them to convert an active business into a long-term passive income stream. For many Americans, real property is their main source of retirement income, and 1031 allows them to build wealth until they need to access it.
Because they allow business owners to reinvest gains on a tax-deferred basis in productive assets with less unsustainable debt, like-kind exchanges can create a ladder of economic opportunity for those who may lack access to traditional sources of financing. This can include minority, veteran, or women-owned businesses. Properties acquired in a like-kind exchange carry around 30% less overall debt than similar real estate acquired outside of an exchange, a figure large enough to offset some of the inherent unfairness in sources of available debt financing. Thanks to 1031, marginalized individuals can avoid taking on bad debt when working toward upward mobility.
These are just a few of the most common myths regarding 1031. In the second part of our blog series , we’re going to discuss popular misconceptions regarding the economic, environmental, and social impact of 1031. The better people understand how 1031 works, the more they’ll be likely to support its continued viability.
Not too familiar with 1031 Exchanges? Visit our 1031 Exchange Guide here.