As many of you know, some members of Congress are assessing whether to repeal Section 1031 of the U. S. Internal Revenue Code, which allows sellers to defer capital gains taxes on exchanges of “property held for productive use in a trade or business or for investment” – by reinvesting the gain on the sale in other qualifying like-kind property. The taxes raised by repealing Section 1031 would be used to finance, in part, a possible tax rate cut.
House Ways and Means Committee Chairman Kevin Brady (R, TX) has proposed replacing Section 1031 with immediate expensing. Immediate expensing works like bonus depreciation: instead of depreciating real estate over a long life (typically 27.5 or 39 years), you would deduct the full value of the building in the initial year of investment. This would create a tax deduction that can be carried forward indefinitely, until it is eventually used up by income from operations or future gains.
Another aspect of the current tax reform proposals has to do with limiting or eliminating certain “tax expenditures,” (in the Administration plan) including deductions for interest expense, or the elimination of “special interest deductions and credits” (in the House GOP Blueprint), also including interest deductions. These provisions would have an immediate impact on the after-tax cash flows of debt-financed business assets, including real estate. Recently, there has been discussion of grandfathering the phase out of the interest deduction for taxpayers with pre-existing debt and possibly exempting it from small businesses.
At issue is whether the loss of Section 1031, in exchange for immediate expensing, would be a fair trade-off. For example, the immediate expensing proposal excludes the expensing of land. Such an exclusion would greatly limit the new deduction, particularly for real estate purchases with a relatively high proportion of land value. Chairman Brady has said recently that he would consider allowing an interest deduction for the acquisition of land, precisely because it couldn't be expensed immediately. So it is possible – though not guaranteed – that there may be modest tax benefits available for the land portion of real property.
Another problem with replacing Section 1031 exchanges with immediate expensing is in the case of a sale of property in one year and acquisition of property in a subsequent year. While immediate expensing may be available, the timing may not align and tax would be due on the gain from sale in the earlier year.
The biggest question is how these changes will impact the real estate market. Will a replacement of the tried-and-true (and fully understood) like-kind exchange provisions, with an immediate expensing provision result in taxpayers simply holding onto their properties, or will they seek other ways (or investments) in order to defer income taxes? Only time will tell.
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