One of the headline proposals contained in the Republican Party’s “Better Way” blueprint for tax reform was immediate expensing of business investments. Although the Blueprint does not directly address like-kind exchanges, commenters immediately began to wonder what role, if any, would be left for section 1031 (which allows taxpayers to defer gain on such exchanges) in a world of immediate expensing. Writing off the replacement property immediately for tax purposes is, in most cases, a better answer than deferring gain on the property disposed of, since the deduction for the write-off can generally be expected to offset or exceed any gain recognized on the disposition. Although section 1031 would still be an important provision for exchanges involving property not subject to the immediate expensing regime (such as land and possibly buildings), concern grew that the provision could be eliminated as part of a reform package.

While REITs do not usually pay corporate income tax, section 1031 is still an important tool for REITs for a number of reasons:

• If a REIT disposes of a property in a taxable sale, it must distribute to its shareholders an amount at least equal to its gain on the transaction or else be subject to tax. If the REIT is pursuing a strategy of organic growth, this required distribution could be a drag on the execution of that strategy. Section 1031 can help a REIT retain more of its capital.
• Section 1031 exchanges facilitate compliance with the prohibited transaction safe harbors that protect REITs against the imposition of the 100% penalty tax on “dealer” sales. Where there is uncertainty about how a sale would be treated, these safe harbors provide that a REIT will not be subject to the penalty tax if, among other requirements, it has seven or fewer “sales” during the taxable year or abides by certain other limitations on fair market value or adjusted tax basis of the properties that are “sold.” Advisors have argued that a section 1031 exchange should not be counted as a “sale” for this purpose, and the IRS has concurred in this analysis in several private letter rulings. Thus, structuring some dispositions as section 1031 exchanges may expand a REIT’s ability to take shelter under these safe harbors. Of course, since assets held in a dealer capacity cannot themselves be disposed of in a section 1031 exchange, careful consideration must be given when using this technique.
• For REITs, especially private REITs, whose shareholders are particularly sensitive to gain recognition, section 1031 serves the same function as it does for any other taxpayer: to facilitate redeployment of capital on a tax-deferred basis. For example, a private REIT whose owners include non-U.S. investors will often agree to limit or avoid property sales to protect those investors from the application of FIRPTA. A section 1031 exchange, however, could enable such a REIT to exit its investments (and enter new ones) without creating taxable FIRPTA gain for its shareholders.

After being sidelined by healthcare for months, tax reform looks to be a priority for Congress and the White House this fall, and changes to section 1031 may be in play. Even if a comprehensive tax reform bill does not move forward, a cautionary tale can be read in the history of the Bipartisan Budget Act of 2015 (the “Budget Act”) and the fundamental overhaul of the partnership tax audit rules contained therein. Those rules were originally devised as part of Congressman Dave Camp’s tax reform process and legislative language implementing them was included in his discussion draft. Although Congressman Camp’s overall vision for tax reform did not gain traction, these specific provisions were a tempting “off-the-shelf” revenue raiser for the Budget Act—and so they were quickly passed into law, to the surprise and dismay of many practitioners and taxpayers, who had little warning that these major changes were even under serious consideration.

President Obama’s 2017 Greenbook included a proposal to restrict the applicability of section 1031, including by limiting the annual amount of gain deferrable through exchanges to $1 million. The Joint Committee on Taxation estimated that this limitation would increase revenues by $37 billion over a ten-year period. By comparison, the Budget Act’s changes to the partnership audit rules were scored for only $11 billion of revenue by the Congressional Budget Office. Even outside the context of comprehensive tax reform, the repeal or limitation of section 1031 could remain “in the air” as a tempting source of revenue that legislators could draw on to balance the fiscal books. Taxpayers should remain alert to the possibility that limitations on section 1031 (and the associated revenue) could find their way into a compromise bill.