“That deferral is a very valuable thing.”
Donald Trump did not like the tax reform Ronald Reagan signed into law in 1986. In an op-ed in The Wall Street Journal, he called it “one of the worst ideas in recent history.” The reason for his dislike was that the reform put the kibosh on real estate tax shelters. "It was a hard time for developers like me,” Trump wrote. “Many of my competitors, as well as the contractors, builders and workers who depended on them, went under.”
If modern-day tax reformers in Congress get their way, Trump and his real estate friends will be in for another major setback. Both Democratic and Republican tax plans are targeting one of the premier tax avoidance techniques used by developers: the deferral of capital gains tax on sales of property when proceeds of the sale are rolled over into the purchase of another property. Deals that get this tax relief are called like-kind exchanges or simply 1031 exchanges after the section of the Internal Revenue Code that is to real estate developers what section 401(k) is to pension consultants.
The threat of cuts to, or the outright repeal of, section 1031 is a dark cloud hanging over investors and developers of commercial real estate. “Like-kind exchange transactions are fundamental to the real estate investment sector,” says the National Association of Realtors. In his book The Tax-Free Exchange Loophole, real estate adviser Jack Cummings calls the like-kind exchange “the greatest real estate investment tool known to mankind.” An industry newsletter stated that repeal of these benefits would have “the potential to have a devastating impact on the real estate market and the larger overall economy.”
A like-kind exchange is an escape valve for capital gains taxes on real estate. With rising real estate prices and the increase in the top capital gains tax rates in 2013, the role of like-exchanges in commercial real estate deals has grown rapidly since the credit crisis in 2008. Approximately one-quarter of all commercial real estate transactions involve a like-kind exchange.
Trump gets paid for allowing his name to be affixed to office buildings, hotels, golf courses, casinos, and men’s shirts. He has also sponsored a series of business books with “Trump University” in the title. In the one on commercial real estate investing, author David Lindahl proclaims, “The declaration of independence tells us that all men are created equal, but the government definitely favors real estate investors!” He goes on to describe the tax break for like-kind exchanges this way: “It’s like an IRA account on baseball steroids. You can legally sell one property and buy another, while deferring all tax payments on your profits.”
Arguing that like-kind exchanges are complex and unjustified, the Obama administration has proposed a $1 million per-year, per-investor limit on capital gains that can be deferred in like-kind exchanges. Before he gave up the chair of the Senate Finance Committee to become ambassador to China, Democratic Sen. Max Baucus suggested repealing section 1031. Baucus cited a 2010 presidential panel report that argued that like-kind exchanges were “adding complexity and providing incentives for socially unproductive tax planning.”
And just last year, then-House Ways and Means Committee Chair Dave Camp proposed a sweeping tax reform plan that included repeal of section 1031. Camp’s explanation of the proposal said that successive like-kind exchanges could result in taxable gains being deferred for decades or, if held by the investor until death, forever. It also noted that section 1031’s uncertain rules gave rise to controversy between the IRS and taxpayers and provided “significant opportunities for abuse.” Congressional economists estimated that Camp’s proposed elimination of like-kind exchanges would raise $41 billion over 10 years.
The powerful real estate lobby will fight these proposals tooth and nail. Members of the 1031 Like-Kind Exchange Coalition include the National Association of Home Builders, the National Association of Real Estate Investment Trust, the National Association of Realtors, and the Real Estate Roundtable. Two economic studies sponsored by the coalition were completed this year. The first study found that repeal of section 1031 would reduce real estate investment and increase rents. Because of the lockout effect, investors would hold real estate longer, and because of reduced cash flow, they would use more debt. The second study found that elimination of like-kind exchanges as part of tax reform would reduce the size of the U.S. economy by 0.04 percent.
The fundamental problem with section 1031 is that it singles out one class of investments for special treatment. There is a legitimate economic argument for reducing taxes on investments, and also for reducing the lock-in effect created by postponing taxes on accrued gains until assets are sold. But the availability of tax benefits from like-kind exchanges encourages investors in real estate to stay in real estate and rushes them to complete deals within the one-year period required under current rules. Purchasers with 1031 gains from a previous sale will pay higher prices to avoid capital gains tax. And as Trump himself knows -- sellers of property (such as his partners in one of his investments) with section 1031 gain are anxious to sell for a low price. The large tax-induced price movements are a clear indicator of economic inefficiency.
The earliest we can expect Congress to tackle broad-based tax reform is after the inauguration of the next president in 2017. If reform ever happens, this landmark legislative achievement would have to include painful cuts in tax breaks for equipment investment, for exporters, for manufacturers, for small business, for high-technology firms, and perhaps even for research and development. In this light it is hard to believe -- even in the face of a white-hot lobbying effort from the real estate lobby -- that Congress could leave tax breaks for office buildings owned by New York billionaires unscathed.
Unless, of course, a New York billionaire is the next president. The latest odds from Irish bookmakers for Trump winning the Republican nomination are 12 to 1. That’s better than the odds for Govs. Chris Christie, John Kasich, Bobby Jindal, or Rick Perry.