IRC Section 1031 Tax Deferral Is a Critical Feature for Real Estate Transactions

This blog post was written by George Ratiu, Director of Quantitative & Commercial Research and Erin Fitzpatrick, Research Intern.

Like-kind exchanges (LKEs) offer a valuable venue to dispose of and acquire similar properties. The Internal Revenue Code (IRC) Section 1031 codifies that the tax owed on any gain after a sale may be deferred as long as the proceeds are reinvested in a similar property through a like-kind exchange.

According to the IRS, “like kind property is property of the same nature, character or class. […] Most real estate will be like-kind to other real estate.”[1] Generally, a parcel of land with a rental house may be exchanged for vacant land. Similarly, an office building may be exchanged for an industrial warehouse or a retail shopping center. The Internal Revenue Service (IRS) also makes note of the fact that while the gain “is tax-deferred […] it is not tax-free.”[2] At some point, the property owner disposes of the property and gains are recognized, leading to tax payments.

Like-kind exchanges provide several major benefits. The main one is the freer flow of capital. LKE transactions allow property owners to allocate capital more efficiently and be flexible in the face of changing economic and market conditions. Another main benefit is that LKE transactions lead to commerce—as they involve multiple parties—as well as economic growth through job creation.

The Like-Kind Exchanges: Real Estate Market Perspectives 2015 report details the potential impacts upon REALTORS® transactions due to the absence of the tax deferral provision of IRC Section 1031. Based on responses, 40 percent indicated that transactions would not have happened at all during 2011-14 without the availability of like-kind exchanges. Another 24 percent reported that about 75 – 99 percent of their transactions would not have occurred, and 18 percent of members marked that 50 – 74 percent of transactions over a four-year period would not have occurred absent the tax-deferral option.

The effect remained significant when respondents were asked about the likely impact upon those transactions which would have occurred even assuming the absence of IRC Section 1031. NAR members’ answers showed that a significant proportion—56 percent—considered the project would have been smaller than it was. Only 12 percent of answers indicated that the absence of like-kind exchanges would have had no effect on their 2011-14 transactions. The question offered respondents the option of selecting “Other” as a choice, with the availability of an open-ended comment response.  The “Other” option garnered 32 percent of answers, with a majority of comments stating that no transaction would have occurred without a like-kind exchange available.

To access the Like-Kind Exchanges: Real Estate Market Perspectives 2015 report, visit http://www.realtor.org/reports/like-kind-exchange-survey.

---

[1] Ibid.

[2] Internal Revenue Service, Like-Kind Exchanges Under IRC Code Section 1031, FS-2008-18, February 2008