Simplification of the Tax Code and elimination of unfair loopholes are noble intentions for the current administration to tackle, but we should be careful to not sacrifice critical provisions of the Code that stimulate the economy in pursuit of this goal.
For instance, take Section 1031, which allows the like-kind exchange. This provision encourages investment in the United States and is a central part of many small investors’ strategies to grow their businesses.
Importantly, the like-kind exchange isn’t a loophole: it has long been enshrined in the tax code as Congress’s accepted way of continuing someone’s investment in productive assets.
As some of you may know, like-kind exchanges allow small businesses and investors to trade rental or business-use real estate (or equipment) for other rental or business-use real estate (or equipment) without an immediate tax penalty, so like-kind exchanges help alleviate high up-front costs for many small businesses. A farmer or small manufacturer can sell old equipment to help fund their upgrades without taking a tax hit.
A typical example is a landlord selling a four-unit building and using an exchange to buy a six-unit building. The landlord can incrementally grow his business while deferring taxes. If the landlord sells the second building instead of exchanging it, she pays the taxes from that sale.
To really understand the effect of like-kind exchanges, it’s important to realize that like-kind exchanges do not eliminate taxes owed. Taxes are eventually paid when the investor “cashes out” by selling the replacement asset in a conventional sale.
In fact, in commercial property exchanges, about 88 percent of replacement properties are eventually disposed of in a taxable sale, and income taxes are paid. The remaining 12 percent could be subject to estate taxes upon the death of the beneficial owner, and the estate tax rates are actually higher than the income tax rates.