Is This the End of Section 1031 Tax-Deferred Exchanges?

By Howard J. Weiss

Is this really happening? Please say it isn’t so. I hate to be the bearer of bad news, but despite the extensive use of 1031 exchanges in the real estate and aircraft industries, there has been a movement on Capitol Hill to revamp or completely repeal Section 1031 as part of comprehensive tax reform. Tax reform proposals by former Senate Finance Committee Chairman Max Baucus (D-MT) and former House Ways and Means Committee Chairman Dave Camp (R-MI) were submitted in 2013 and 2014 to repeal Section 1031 of the Internal Revenue Code and use the additional tax revenue to finance a lower corporate income tax rate. In addition, President Obama’s 2015 budget proposed to limit the deferred gain on real estate sales to $1 million per taxpayer per year.

Section 1031 of the Internal Revenue Code was originally enacted in 1921 and has been used in commercial real estate, as well as aircraft and aviation sales, to permit tax deferral on the exchange of “like-kind” property. A Section 1031 exchange promotes reinvestment in replacement property by allowing the seller to defer taxes, rather than pay taxes, on the sale of certain classes of assets. For purposes of Section 1031, “like-kind” means that the property being purchased (i.e., the replacement property) is of the same nature, character or class. The replacement property, however, does not need to be identical to the property being sold (i.e., the relinquished property).

While most real estate will be like-kind to other real estate, aircraft and aviation equipment are considered tangible personal property that must also be evaluated based upon General Asset Class and Product Class under the tax regulations. In addition to the like-kind requirement, the replacement property and the relinquished property must be held for investment purposes or for use in a trade or business. Therefore, real estate and aircraft held primarily for personal use do not qualify for like-kind treatment.

According to an Ernst & Young study in March 2015 entitled “Economic Impact of Repealing Like-Kind Exchange Rules,” repeal of Section 1031 would not only have an adverse impact on the real estate industry, but it would also significantly affect the U.S. economy. The Ernst & Young study estimates an economic impact of $8 billion per year to the real estate industry and a reduction of $26 billion annually to the nation’s GDP. The reduction in GDP is based upon the total impact on the top 10 sub-industries that engage in like-kind exchange activity (e.g., transportation, construction, oil and gas, equipment rental and leasing, etc.).

In addition to the negative economic impact upon the economy, the repeal of Section 1031 would impose a higher tax burden on real estate investors and owners of commercial aircraft upon the sale of their assets.

“If Section 1031 is repealed, the aviation industry will significantly suffer as the sale and trade-in of business aircraft will be drastically reduced due to the tax consequences,” said Curt Pavlicek, president of Pinnacle Aviation in the Scottsdale Airpark. “In essence, the purchase of replacement aircraft will be limited causing aircraft manufacturers to slow production ultimately causing layoffs.”

In commercial real estate, most investment properties are owned by a partnership or limited liability company, therefore “passing through” the tax liability to the individual owners of the entity. To make matters worse, these individuals will not benefit from the lower corporate income tax rate that the repeal of Section 1031 is supposed to finance. It will be interesting to see how the repeal of Section 1031 and the lowering of the corporate tax rate, if enacted, will affect the form of entity in which real estate investors choose to hold their properties.

The Scottsdale Airpark is uniquely situated to reap the benefits of Section 1031 exchanges based upon its concentration of business in the real estate and aviation industries. The repeal of Section 1031, however, could have a significant economic impact on the future of Scottsdale’s largest employment base.

Howard J. Weiss is a partner at Nussbaum Gillis & Dinner P.C. in Scottsdale. His practice is focused on counseling clients regarding the purchase, sale and lease of commercial real estate, as well as business transactions and entity formation. Weiss may be contacted at (480) 609-0011 or by email at hweiss@ngdlaw.com.

The information contained in this column is for informational purposes only, and should not be construed as providing legal advice or tax advice. If you have any questions regarding the topics discussed herein, you are advised to contact an attorney or tax adviser.