FAQs

What are §1031 Like-Kind Exchanges?

Like Kind Exchanges, also known as tax-deferred exchanges, are defined by Internal Revenue Code §1031. Since 1921, IRC §1031 has permitted a taxpayer to exchange business-use or investment assets for other like-kind business use or investment assets without recognizing taxable gain on the sale of the old assets.  The taxes which otherwise would have been due from the sale are thus deferred.  Section 1031 transactions range from relatively simple “trade-ins” or 2-party “swaps,” to more complex non-simultaneous §1031 exchanges involving separate buyers and sellers. Qualifying assets include commercial, agricultural and rental real estate, aircraft, trucks, trailers, containers, rail cars, agricultural equipment, other heavy equipment, livestock and other assets involved in a broad spectrum of industries.  Tax rules for non-simultaneous exchanges require the use of an independent third party Qualified Intermediary (“QI”).  The QI holds the sale proceeds for the benefit of the taxpayer during the exchange, disbursing funds for purchase of like-kind replacement property, and returning any unused funds to the taxpayer at the end of the exchange. Section 1031 exchanges must be completed within 180 days. Taxpayers recognize gain and pay tax on any unused funds or when they ultimately “cash out” of their property.

Who uses like kind exchanges?

All businesses, manufacturers, real estate investors, companies in the construction, trucking, rail, marine and equipment leasing industries, farmers, ranchers, individuals and more make good use of like-kind exchanges. §1031 like-kind exchanges are one of the few incentives available to and used by taxpayers of all sizes. A recent industry survey showed that 60% of exchanges involve properties worth less than $1 million, and more than a third are worth less than $500,000. Qualified Intermediaries (QI) facilitate non-simultaneous tax-deferred exchanges of investment and business use properties for taxpayers of all sizes, from individuals of modest means to high net worth taxpayers and from small businesses to large entities.

What are the benefits of Like Kind Exchanges?

Following a like kind exchange, the business or investor is left with more working capital and can roll that money back into the business. The economy benefits because the business owner cannot receive a tax deferral benefit without reinvesting those savings back into the business, so businesses are encouraged to expand or upgrade their properties, machinery, equipment and other assets. Since properties located or used within foreign countries are not like-kind to assets in the United States, §1031 promotes reinvestment and job growth within our U.S. borders.
Read more in the Industry Papers section.

Does the tax ever go away?

With §1031 exchanges, taxes are deferred but not eliminated. These legitimate transactions utilize an important tax planning tool. Payment of tax occurs:

1. upon sale of the replacement asset;
2. incrementally, through increased income tax due to foregone depreciation; or
3. by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.

What are the tax policies upon which §1031 exchanges are based?

• §1031 has remained in the tax code since 1921, notwithstanding repeated Congressional scrutiny, because it is based on sound tax policy that is predicated on continuity of investment by the taxpayer.
• §1031 is consistent with goals of efficiency, neutrality, fairness, and simplicity within the tax system.
• §1031 promotes business decisions that stimulate U.S. job creation and growth of the U.S. economy.
• §1031 promotes efficient use of productive capital and operating cash flow.
• §1031 exchanges facilitated by Qualified Intermediaries are neither abusive nor administratively difficult for either the IRS or taxpayers.
• §1031 benefits and is widely used by a broad spectrum of taxpayers at all levels, in all lines of business, including individuals, partnerships, limited liability companies, and corporations.

§1031 and the Economy

How do §1031 Like Kind exchanges stimulate the economy?

Like-kind exchanges contribute to the velocity of the economy and promote job growth within the United States. §1031 stimulates the economy, encouraging real estate transactions, and encouraging companies to replace and upgrade machinery and equipment, stimulating purchases and sales of machinery, equipment, railcars, aircraft, trucks and other vehicles sooner, because tax on the gain can be deferred.
Owners of personal property assets used predominantly in the United States may only obtain tax deferral benefits by reinvesting in like-kind domestic assets. An energy company, for example, cannot receive tax deferral benefits for selling mining, gas and oil field machinery in Texas and moving their production activity to Canada. §1031 provides a strong incentive to multinational companies to maintain and increase investments in the US.
Transactional activity results in taxable income, job growth, manufacturing, financial services, construction, improved neighborhoods and tax revenue to states and local communities. Ultimately, this economic stimulus spills over to create jobs in factories, restaurants, recreational, hospitality, tourism and other local small businesses that generate revenue from the after tax dollars of employed workers.

How can §1031 exchanges benefit businesses, and ranchers and farmers?

For all businesses, §1031 permits efficient use of productive capital and cash flow while allowing taxpayers to shift to more productive like-kind property, change geographic locations, diversify or consolidate holdings, or otherwise transition to meet changes in business needs or lifestyle. Tax-deferred exchanges provide an important stimulus to a multitude of economic sectors, having local, national and global effect.
Farmers and ranchers use §1031 to combine acreage or acquire higher grade land or otherwise improve the quality of the operation. Retiring farmers are able to exchange their most valuable asset, their farm or ranch, for other real estate without diminishing the value of their life savings.

How can like kind exchanges be used for conservation and environmental policies?

§1031 is used to promote conservation and environmental policies. Grants of conservation easements can be structured as tax-deferred exchanges, facilitating government and privately funded programs designed to improve water quality, reduce soil erosion, maintain wetlands and sustain critical wildlife habitat. These exchanges also enable landowners to acquire replacement farm or ranchland in less environmentally sensitive locations.

How does depreciation impact exchanges to make §1031 revenue neutral?

When a depreciated asset is exchanged under §1031, the taxable gain / depreciation recapture is not recognized, but rather is rolled into the new asset. Depreciation is only allowable for any remaining tax basis and for value representing additional capital investment into a like-kind asset. For example, a company vehicle has a fair market value of $10,000, but it is fully depreciated. It has a tax basis of $0 and depreciation recapture gain of $10,000 at the time of sale. If it was exchanged for a replacement vehicle at a cost of $10,000, that replacement vehicle would have the same tax characteristics and no further depreciation would be allowed. If the replacement vehicle cost $25,000, then only $15,000, representing the additional investment, would be available for additional depreciation over a new tax life. If the relinquished company vehicle was not fully depreciated, but had a remaining tax basis of $2,000, and the new vehicle cost $25,000, then the maximum depreciation allowed on the replacement vehicle would be $17,000 (remaining tax basis plus additional investment).

The total depreciation expense allowed over the life of an asset which participates in an exchange or an ongoing exchange program is no greater than the depreciation expense of an asset that does not participate in an exchange or exchange program. Section 1031 benefits the taxpayer by permitting immediate reinvestment of the entire amount of sale proceeds back into the business, rather than impacting cash flow by forcing that taxpayer to recoup that capital investment slowly, over a multi-year depreciation schedule. Essentially, it provides a cash flow timing benefit.

Over the tax life of a depreciable asset, the dollar impact of §1031 to the U.S. Treasury is zero.

Tax Reform

Will a repeal of §1031 accomplish the goals of tax reform set by Congress?  No!

• Repeal of §1031 will not accomplish the goals of tax reform
• Repeal of §1031 will not Increase fairness
• Repeal of §1031 will tax cash flow, not wealth
• Repeal of §1031 will not raise significant revenue
• Repeal of §1031 will cause a decline in real estate values, a drop in manufacturing, and economic stagnation
• §1031 encourages reinvestment over profit taking, and it provides a strong incentive to keep that investment at home, in the United States.

Can retention of §1031 laws help achieve goals set by Congress?  Yes!

The House Ways and Means Committee stated, “Every dollar small businesses spend on taxes and tax compliance is a dollar they do not have to invest in equipment, start a new production line, hire a new employee or provide more in wages and benefits.”(1) The Committee further posited, “Our outdated international tax system actually encourages American businesses to keep profits and jobs outside of America.”(2) The Committee concluded, “Simply put, if taxes were not so high…businesses would have the resources to reinvest in their businesses and help grow the economy of their communities.”(3)
The tax deferral benefit provided by §1031 is a valuable tool for meeting all of these goals. It provides a powerful engine to the US economy. Like-kind exchanges promote transactional activity that results in jobs and taxable income that, in turn, fuels other businesses, including small and mid-sized businesses. And since foreign real estate and assets used predominantly outside of the United States cannot be exchanged for domestic real estate and assets such as machinery and equipment, the §1031 deferral benefit directly stimulates reinvestment in U.S. communities and businesses, promoting job growth within our own borders.
1 “The Tax Reform Act of 2014, Fixing Our Broken Tax Code So That It Works For American Families and Job Creators,” House Ways and Means Committee, p.11.
1 Ibid., p.9
1 Ibid., p.10

Is IRC §1031 a loophole?  No!

IRC §1031 is a powerful economic engine based on sound tax policy. The non-recognition exchange policy is premised on the understanding that the taxpayer continues with the same qualifying investment, with no intervening receipt of cash, and is left in the same tax position as if the relinquished asset was never sold. This valuable section should be retained in its current form because it accurately reflects the economic reality of investment continuity in which no profit is taken, thus there is no premise to tax.

Is §1031 an “abusive tax avoidance scheme?” No!

IRC §1031 provides only a temporary deferral; taxes are not eliminated. Tax will be paid either:

1. upon sale of the replacement asset, or
2. incrementally, through increased income tax due to foregone depreciation, or
3. by inclusion in a decedent’s taxable estate, at which time the value of the replacement asset could be subject to estate tax at a rate more than double the capital gains tax rate.

What are the risks of repealing §1031?

• Repeal of Section 1031 will cause a decline in real estate values
• Elimination of §1031 would result in a substantial increase in depreciation deductions and reduced income tax revenue.
• Elimination of §1031 would have a chilling effect on real estate, manufacturing and other business transactions.
• Fewer transactions also translate into fewer jobs not only in the §1031 exchange industry, but also in the real estate, construction, title insurance, mortgage and other related industries, equipment lease financing, vehicle and heavy equipment rental and manufacturing, after-market alteration, customization and installation industries.

How would repeal of 1031 affect the cash flow of a business?

Elimination of §1031 would tax cash flow, not wealth. §1031 permits a continuity of investment by the taxpayer without reducing cash flow available for growth of the business. The value of assets exchanged, whether farmland, commercial or rental residential real estate, machinery, equipment, vehicles or other business-use or investment assets, remains invested in the taxpayer’s business.
Without the current treatment under §1031, cash-strapped owners of business-use and investment assets could be forced to downsize their businesses, farms, ranches, real estate holdings, etc. if they don’t have sufficient additional cash flow to acquire replacement assets and pay tax on the gain or depreciation recapture of the old asset.

Will longer depreciation schedules introduced by proposed depreciation pools unfairly impact taxpayers that are taxed at individual rates?

Unlike corporations, farmers, ranchers, real estate owners, and others holding assets in pass-through entities will be unfairly and negatively impacted by substantially reduced depreciation deductions coupled with individual tax rates that will be higher than the targeted 25% corporate rate. The effect of the depreciation pools is that depreciation for many assets will exceed the life of the asset. For example, farm equipment purchased at a cost of $300,000 which under current rules would be subject to 7 year MACRS, would be fully depreciated in its 8th year of ownership. That same unit of agricultural equipment, under the Pool 2 proposal, would not be fully depreciated until its 30th year of ownership, long after its useful life has ended. The combination of present MACRS depreciation rules with §1031 exchanges provides a stronger cash flow benefit and therefore, a stronger economic stimulus to businesses. Elimination of §1031 with a transfer to a pooling depreciation method will cause these individual taxpayers and small businesses to retain assets longer, since there is a reduced cash flow incentive to reinvest.