Anyone with an electronic device has heard of the pressures from left and right to “reform” the tax code, due to its complexity, unfairness, or just plan bulk. One closely watched plan proposed by Senate Finance Committee chair Max Baucus, is found in the third of “staff discussion drafts” advanced for contemplation of means to modify or eliminate 1031 exchanges.
For the lay person, this is a device which is either designed to eliminate tax impediments to reinvesting the profits from a real estate sale or to let the rich stay rich, depending on your point of view. In practice, the owner of a property plans on selling. Under normal circumstances, the seller is taxed at capital gains rates, currently already a preferential 10-25% rate, depending on the individual’s tax rate, on the difference between the acquisition cost (“basis) and the sale price. The theory for that lower rate that passive income should be taxed at a lower rate than ordinary income from labor. A prudent investor can defer the application of that tax to the indefinite future by taking the proceeds of sale and reinvesting all or most into “like kind” assets. In theory, the government does collect tax at the end of the day, when the last property is sold. But, the essence of this procedure is that an owner of income property can delay paying tax, and is thereby given an incentive to reinvesst in new capital. The reality is that many of these investors never pay tax, because of the application amother element in the tax code, a “step up” in basis, which for heirs of the owner, if they take the property at his or her death, tax is eliminated because the IRS moves the basis up to the value at the death of the original owner. Any tax they pay will be the difference between the stepped up basis and the increase in value at the heirs sale of the asset.
One can see that this device is a terrific tool for a real estate investor, regardless of your political slant. As that tool is more likely an advantage to a more wealthy investor in real estate, you can expect those with real estate and other wealth will fight hammer and tong to save this provision in the tax code.
See an expanded discussion of the proposed elimination of the 1031 exchange in a blog post by Alexander J. Szilvas, Christina Novotny, and Lucas L. Witters of Baker Hostetler: