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The Tax Loophole of 2016: Like-Kind Exchange

May 18, 2016 at 4:30 PM

Donald Trump’s real estate background is shining a much-needed spotlight on a major tax loophole that policymakers should close — “like-kind exchange.”  It’s an arcane provision in which individuals and corporations can buy and sell assets — like real estate or art — that have grown in value and still avoid capital gains taxes, costing the government billions a year.

So how does a like-kind — known technically as Section 1031 of the Internal Revenue Code — exchange work?

  • Selling or exchanging property generally triggers capital gains tax if the asset’s value has grown.  If, say, an investor buys stock worth $1 million and later sells it for $1.5 million, the investor pays capital gains tax on the $500,000 gain ($1.5 million less $1 million).  That’s true even if the investor uses the proceeds to purchase stocks in another company.
  • But Section 1031 provides that property held for use in a trade or business or for investment does not trigger the capital gains tax if it’s exchanged for “like-kind” business or investment property.  Any gain on a like-kind exchange isn’t subject to tax until the owner sells the replacement property.  Moreover, the owner can defer the tax once again at that point by applying the replacement property to yet another “like-kind” exchange.
  • Lawmakers seemed to design the provision originally to exempt small-scale and barter transactions (think of farmers trading horses).  But it’s now used for commercial real estate, expensive artwork, airplanes, rental car fleets, and many other assets.  A wealthy investor can effectively buy and sell buildings while paying no capital gains taxes.  In fact, investors can defer such taxes for their entire lifetimes (and the taxes can then be wiped out altogether at death through another loophole).

Because of the arcane rules around making a like-kind exchange, a cottage industry of tax lawyers and lobbyists is dedicated to helping wealthy people and companies make these deals and to lobby policymakers against ending the loophole.  Consider this excerpt from a site promoting these exchanges:

[A] 1031 exchange can allow a real estate investor to shift the focus of their investing without incurring the tax liability.  For example, perhaps you are investing in properties that are low-income and thus high-maintenance.  You could exchange the high-maintenance investment for a low-maintenance investment without needing to pay a significant amount of taxes.  Or perhaps you want to move your investments from one location to another without the IRS knocking.  The 1031 makes this possible.

This loophole begs for reform, as key players recognize.  President Obama’s 2017 budget would limit the amount of capital gain deferred through like-kind exchanges to $1 million per taxpayer per year and deny any such exchange for artwork or other collectibles.  This proposal would save $47 billion in revenues over ten years, the Treasury Department estimates.  Former House Ways and Means Chairman Dave Camp proposed eliminating like-kind exchanges.  Let’s hope that more focus on this loophole will convince policymakers to close it.

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