Pay Now or Pay Later: Like-Kind Exchanges and Depreciation

Are 1031 Exchanges simply a loophole for wealthy taxpayers?

No. Like-kind exchanges provide individuals and businesses, both small and large, incentive to replace old investment property and business-use assets with new assets that are like-kind. The economy is stimulated in exactly the way intended when Section 1031 was written in 1921 – by allowing for the continued sale and purchase of real estate for business use. Deferring taxes on the sale of the old assets makes the purchase of new assets possible.

Doesn't the government lose revenue as a result of 1031 exchanges?

When a like-kind exchange occurs, Section 1031 provides the mechanism to defer taxable gain recognition in return for reinvestment of 100% of the sales proceeds back into a “like-kind” asset, and it accounts for the new asset on the tax books in a specific manner: Every dollar that is deferred in a 1031 exchange must be subtracted from the amount that can be depreciated from the replacement asset.

The U.S. Treasury immediately offsets tax revenue losses by disallowing future tax depreciation equal to the gain that was deferred under an exchange. So, when a company files its taxes the year following a deferral, less depreciation expense is taken due to the disallowance and more income tax is paid. Over the tax life of the replacement property, the foregone depreciation is EXACTLY equal to the original deferral amount. The extra taxes collected by the U.S. Treasury during the tax life are also EXACTLY equal to the taxes otherwise paid under a sale transaction. This relationship between deferral and depreciation is outlined in a paper recently released by the Federation of Exchange Same as intermediary, facilitator, or Qualified Intermediary. The party who facilitates a tax-deferred exchange by acquiring and selling property in an exchange to aid the taxpayer in complying with Section 1031 and all applicable rules. Accommodator s, "Understanding the Impact of Depreciation on Like-Kind Exchanges."

Conclusion

Section 1031 provides for tax deferral – not evasion or abuse – and the benefit to the taxpayer is one of timing. Would you rather pay the tax now or later? (“Exchangor” or “Taxpayer”) Person intending to conduct a 1031 tax deferred exchange, who transfers a relinquished property and thereafter receives a replacement property. Exchanger s opt to reinvest the revenue from asset sales into updated assets that allow them to stay competitive. The tax is paid in the reduction of depreciation that the U.S. Treasury allows, and the timing benefit to the taxpayer provides the cash-flow necessary to grow their business.