The Continued Attack on Section 1031 exchanges

Published on: 10:56AM Jul 03, 2014

In the FY2015 budget proposal released by President Obama back in March of this year was certain provisions of importance to farmers. One provision is the permanent extension of Section 179 at the $500,000 level. This would be a welcome change, however, as previously discussed in several posts, this will not happen until after the mid-term elections.

Another provision that is also of importance is major proposed changes to Section 1031 exchanges. Under current law, a farmer is allowed to sell farmland (or other assets) for unlimited gains and as long as the proceeds from the sale is rolled over into other qualifying property, the gain is fully deferred until the property is fully disposed of (or if the person dies, a full step-up in basis will remove the gain from taxation permanently).

President Obama's budget proposal would limit the amount of gain from real property that could be deferred to $1 million on an annual basis (indexed to inflation). Here is the actual wording on the reasons for the change:

There is little justification for allowing deferral of the capital gain on the exchange of real property. The difficulty in valuing exchanged property is a primary historical justification for1031 deferral. However, this rationale has limited appeal. For the exchange of one property for another of equal value to occur, taxpayers must be able to value the properties. In addition, many, if not most, exchanges affected by this proposal are facilitated by qualified intermediaries who help satisfy the exchange requirement by selling the exchanged property and acquiring the replacement property. These complex three party exchanges were not contemplated when the provision was enacted. They highlight the fact that valuation of exchanged property is not the hurdle it was when the provision was originally enacted. Further, the ability to exchange unimproved real estate for improved real estate encourages “permanent deferral” by allowing taxpayers to continue the cycle of tax deferred exchanges.

I have underlined some of the reasons that I would like to expand upon:

  • In my opinion "the difficulty in valuing" property was not the primary historical justification for 1031 deferral. Simply, the law was intended to allow the taxpayer to exchange real property for other real property and defer the gain since the taxpayer would be in the same shoes after the exchange (and not have cash to pay the tax).
  • Taxpayers were always able to value the properties since if they did not value the property, why would they do the exchange. If they sold property for $1 million, you can count on the taxpayer knowing the value of the replacement property being $1 million.
  • The qualified intermediary (QI) was brought into existence by Congress in response to the "Starker" case. Congress could have just as easily written the law to provide for rules applying a 45 day identification rule and 180 rollover rule without the need of the QI. You can't state that the three party exchanges were contemplated when the provision was enacted when in fact, Congress created the provisions.
  • The Section 1031 rules do encourage "permanent deferral" and that is not necessarily a bad idea.

As you can see, President Obama has "reasons" for these changes, but it is fairly obvious this is not a correction of a "loop-hole" but rather an attempt to raise revenue. We will keep you posted on these proposed changes, but again, this will not happen before the mid-term elections. however, all bets are off after those elections and before December 31, 2014.