H.R. 1 of the 115th Congress (the “House Bill”) has elements of H.R. 1 of the 113th Congress (the “Camp Proposal”).  However, there are big differences between the two bills. In contrast to the House Bill, the Camp Proposal was a real tax reform proposal. It truly simplified the tax code. It repealed many special provisions that reduced taxable income. In technical terms, it expanded the tax base.

The Camp Proposal was also a net revenue raiser. The Congressional Budget Office projected that the Camp Proposal would generate 3 billion dollars over the 10 year term ending 2023. The House Proposal, by contrast, is estimated (by those who are presenting the proposal in the most favorable light) to reduce tax revenue over the next 10 years by $1.5 TRILLION. Others forecast the true cost at as much as $3,000,000,000,000. That mesmerizing number is $3 trillion.

The Camp Proposal is designed to achieve tax policy goals. I’d approach those goals differently. Despite disagreeing with the methods of achieving those policy goals, I admire the Camp Proposal. It’s a respectable legislative effort to expand the tax base and reduce income tax rates. It simplified the Code without increasing the federal government budget deficit.

The House Bill, in contrast, appears to be driven by a predominant desire to cut taxes. The House Bill contains some of the simplifying elements of the Camp Proposal, but, those seem to be driven more by politics than policy. Other elements of the House Bill introduce mind-numbing complexity (like the special rate for pass-though “business” income). It achieves a tax cut at the expense of complicating the Code. In short, the House Bill lacks the coherent tax policy features of the Camp Proposal.

Noteworthy Features

According to the folks in DC who know best, the House Bill as drafted will not be enacted. However, elements of it may survive. And those items that survive may be effective as of January 1, 2018. That provides little time to plan for these changes. So, it makes sense to assume that certain elements of the House Bill will become law. The following presents my initial thoughts on changes to section 1031 and how they will affect 1031 transactions. In other posts, I’ll consider some of the other items.

1031 Exchanges

The House Bill repeals 1031 exchanges for personal property. Only real property exchanges can qualify for 1031.

Many (and I suspect most) 1031 exchanges are deferred exchanges. Most deferred exchanges are forward deferred exchanges. In a forward deferred exchange, the taxpayer sells relinquished property before acquiring replacement property.

At closing of the relinquished property, a qualified intermediary takes proceeds of sale to hold for certain periods while the taxpayer identifies and acquires replacement property. Presently, the QI typically takes all of the proceeds of sale. If any of the proceeds are paid to the taxpayer, the taxpayer is treated as receiving boot. Boot is taxable to the taxpayer up to the amount of the taxpayer’s gain. The taxpayer also receives boot to the extent that it has a net reduction in liabilities in the exchange.

If only real property qualifies for 1031 exchange treatment, the taxpayer selling a building will recognize gain on the sale of any personal property sold as part of the building’s sale.

If some of the gain from the sale of a building cannot be deferred and is immediately taxable, it would make sense to allow the taxpayer to take proceeds from the sale of those assets and give the balance to the QI. Sounds easy when you say it fast. It’s not easy, though. Avoiding boot on the real estate assets of building sale with a mix of real and personal property will require some thought – and some guidance from IRS:

• Will IRS treat any cash taken at closing as relating to boot from the real estate sale?
• What if the real and personal property are security for a loan (as is almost always the case)? Will any debt discharge in the exchange be treated as boot? Or will boot be limited to the amount traced to the real property? How will that traced amount be determined?

A lot of real estate investors aggressively characterize building assets as personal property. These investors’ positions are often supported by “cost-segregation” reports. These reports are sold by accounting firms and others who look at all of the building’s assets to determine which can be characterized as personal property. They sell the reports to investors promising to significantly reduce annual income and therefore boost after-tax NOI.

In light of changes to section 1031, cost segregation may be a net loser for real estate investors. Investors should calculate the net present value of the additional depreciation deductions cost segregation offers in light of (i) the fact that the depreciation is recaptured at ordinary rates, and (ii) the fact that none of the gain recognized on the sale of personal property will be eligible for gain deferral.

 

 

 

 

 

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