The Tax Cuts & Jobs Act (TCJA) contains a number of significant changes which will have an impact on businesses, individuals and families. Prominent among these changes is the elimination of Section 1031 tax-deferred exchanges involving personal property.
Prior to the TCJA, Section 1031 exchanges involving personal property comprised a substantial percentage of all exchanges. Many companies in the U.S. specialized in performing personal property exchanges for individual investors and businesses. Even if they don’t specialize in 1031 transactions, all attorneys in the U.S., regardless if they be a New York tax attorney, Baltimore divorce attorney or federal circuit court judge – should be aware of this change.
During the time leading up to the TCJA, the elimination of Section 1031 exchanges – both real property exchanges and personal property exchanges – was a serious matter of debate among legislators, but ultimately real property exchanges survived the final revisions. Legislators viewed real estate exchanges as a significant source of revenue but ultimately the lobbying efforts from the real estate industry persuaded legislators to keep that segment of the code alive. The elimination of personal property exchanges under Section 1031 means that investors won’t be able to change their investment property without creating a taxable event, and this will undoubtedly lead to changes in personal property investing. Businesses which were previously able to change their investment property on a regular basis – say, rental car agencies, for instance – will have to find ways to grapple with this shift.
While there’s not much room for debate on the question of whether this change will generate returns for the federal government on a short-term basis, the wider impact of this change remains much more uncertain. The removal of personal property exchanges will negatively affect many businesses, and it may deter individual investors from selling and reinvesting their personal investment property.
Basics of Personal Property Exchanges
Section 1031 of the IRC allows investors to defer recognition of capital gain taxes when they reinvest proceeds from the sale of their investment property in other property of like-kind. In addition to real estate, certain types of personal property were also eligible as “relinquished property” under 1031. For instance, an airplane or automobile held for investment or business purposes was eligible to be used in a 1031 exchange prior to the TCJA. Just as with real estate, personal property exchanges had to satisfy the “like-kind” requirement, and this requirement was more strict when compared with real property exchanges. Personal property could only be exchanged for other personal property of the same “asset class,” and these asset classes were outlined by the Treasury Regulations.
Implications of the Elimination of Personal Property Exchanges
In the short-term, the elimination of personal property exchanges will translate into greater revenue for the federal government as the sale of every piece of personal investment property will create a taxable event. If an investor owns an antique automobile which has a selling price of $1 million and a basis of $250,000, and the investor has been holding the automobile for investment, then that investor will be liable for taxes on the gain of $750,000 whenever he or she decides to sell. Even if certain investors are deterred from cashing out as a consequence of this change to the code, the federal government will undoubtedly see gains from these types of sales in the immediate future.
No matter how individual investors react to this change, the federal government will definitely see large gains from business entities which benefitted from personal property exchanges. Formerly, a car rental agency could swap out its lineup of rental cars for new models after taking all depreciation deductions without incurring a tax liability; the same was true for other companies, such as airlines, which have large amounts of money invested in depreciable personal property assets. The elimination of Section 1031 exchanges will have a substantial impact on the budgets of these types of companies. Companies will have to search for creative ways to tackle this budget issue, and the wider economy may be dragged down as companies purchase fewer pieces of “replacement property” and with less frequency.
The elimination of personal property exchanges will have an impact on the wider economy because these exchanges provided business for facilitators. Facilitators which focused exclusively on personal property exchanges went out of business the moment that the TCJA went into effect, while other facilitators (who perform real and personal property exchanges) will see a drop in revenue. What’s more, the elimination of these exchanges also translates into less work for other professionals associated with the 1031 industry. Appraisers, brokers, lawyers and others who previously performed services for personal property exchanges will have to search for other business in order to make up the deficit. In other words, eliminating these exchanges won’t only affect investors and facilitators, it will also affect other professionals who regularly performed services to make these exchanges possible.
Whether the elimination of personal property exchanges will have a net positive impact on the American economy as a whole is a question which remains unsettled. One well-known study claims that the majority of real property exchanges ultimately lead to taxable sales, and if this also applies to personal property exchanges, the federal government may end up in a worse financial situation than if these exchanges had been preserved. Clearly, the driving force behind this code change was short-term funds for the federal government, and in this respect the change will succeed. Depending on precisely how this change impacts the total economy, Americans may end up suffering financially in the long-term. We may end being punished for failing to stay true to one of the central purposes of Section 1031: the promotion of economic activity for the benefit of our whole society.