WASHINGTON / CATHERINE COLLINS : Massive Tax Loophole Comes Down to Just Two Little Words: Let’s Swap
In the tortuous cycles of tax reform, Congress has closed loophole after loophole and imposed new taxes in the effort to reduce the national deficit.
But if you still want to swap two red cat’s eyes for a couple of aggies and a green shooter, no one at the Internal Revenue Service will give you more than a glance. The same is true if you exchange an apartment building for farmland, or a strip shopping mall for an industrial park.
These “swaps,” or “like-kind” or “tax-deferred” exchanges, have survived, at least for now, and they have become a big business in California.
Whatever the nickname, they are officially known as Section 1031 of the Internal Revenue Code. Like-kind exchanges can apply to almost anything other than your home and stocks and bonds. But they are primarily used as a means to dispose of, and acquire, new residential, commercial or industrial real estate while deferring the tax on the transaction.
Section 1031 is one of the oldest sections of the code--dating to the 1920s--and probably has its roots in the agricultural community.
“The tax provisions allowing swaps probably made a lot of sense in the 1920s, when there wasn’t a lot of cash in the system,” said Adam Handler, an attorney with the Los Angeles firm Sidley & Austin and a former tax counsel at the Treasury Department.
“For example, let’s say there were two farmers. One needed a larger tract in the back end of his property and (the other) needed some new frontage,” Handler said. “Well, they could just trade deeds and they were just exchanging like-kind properties. There was no cash involved. So you can argue that they haven’t really changed their investments and that it is not a proper moment for taxation. They probably wouldn’t have had the cash to pay tax anyway.”
For a long time, like-kind exchanges were used primarily by the most intrepid taxpayers because the exchanges had to be simultaneous. A 1979 court decision, Starker vs. United States, changed that.
Starker sold valuable timberland but refused to accept any money from his buyer, only a contract establishing a future exchange. The contract gave Starker five years to locate new property, at which point the timberland buyer would use the money to purchase the new land and give to Starker.
The IRS challenged the arrangement, but a U.S. Court of Appeals found in Starker’s favor. Many variations of such exchanges have become popular over the years because of some fine-tuning of the legislation and increases in the capital gains tax.
At least half the real estate transactions in California are actually exchanges, according to Richard L. Sevin, president of a Los Angeles company that specializes in such transactions, American Deferred Exchange Corp.
The appeal of the like-kind exchange is simple. “It is one of the few remaining devices in the internal revenue code to defer tax,” said Howard Levine, a partner at the Washington law firm Roberts & Holland. “If there were a substantial capital gains differential, there might be less interest in the tax-deferred exchange.”
This is how it works: If you sell for $1 million a building purchased for $100,000, you would pay a 28% capital gains tax, or $250,000, on your $900,000 gain. If, however, you intend to reinvest in a similar property, you can avoid the tax by having your buyer deposit the money with an independent third party, allowing you to literally swap your property for another.
Congress in 1984 required that the third party not be related to you and that you identify the new property within 45 days and close the deal within 180 days. Also, the new property must be equal to, or greater in value, than the old property. One damper on the deal: In California, property tax assessments often rise dramatically when land changes hands.
There has been talk in Congress over the years of eliminating the provisions allowing these transactions. But even this year, as legislators struggled to slash the deficit, it remained intact despite estimates by federal officials that it cost the Treasury $500 million a year to subsidize like-kind exchanges. However, Sevin estimated that it costs the government that much annually in California alone.
An insider says that the provisions seem fairly safe in the Senate, where the real estate lobby is particularly powerful. Any possible change is likely to emerge from the House Ways and Means Committee, where other constituencies are just as powerful.
Levine argued that many of these deals would not be done without Section 1031.
“This is not a loophole because it clearly was intentional,” Handler said. “It is not a glitch in the tax code, although it may be a dinosaur. Personally, I think it will die a death of a thousand cuts. . . . There will be a huge hue and cry from the real estate industry, but it will get smaller and smaller and apply to less and less.”
Financing Health Benefits for Retirees
Big firms won a quiet but potentially substantial victory when Congress approved changes that will allow employers to pay health benefits for retirees with money from surplus pension funds.
A coalition that included AT&T;, DuPont, Pacific Telesis Group and Pacific Gas & Electric lobbied hard for the new rule. Under the change, assets greater than what is required to meet a pension plan’s obligations can be used, under certain conditions, to pay health benefits for retired workers.
Unions and other advocates for pension recipients, such as the American Assn. of Retired Persons, fought the move. They argued that surplus pension funds should be used to improve the benefits of workers and retirees.
But pressure to reduce the federal budget deficit gave the employers the boost they needed to win. The change is expected to save the Treasury $1 billion over five years because the excess pension funds will be used to pay retiree health benefits that otherwise would have been funded with tax-deductible corporate funds.
However, the employers were forced to accept some restrictions. Companies that terminate pension plans to grab the excess funds for other purposes, called a reversion, face an excise tax on the surplus of up to 50%, a whopping increase from the previous 15%.
“It would have been better had the reversion proposal not passed, but the other side retreated from their position of requiring cost-of-living adjustments and other benefits to retirees which had not been promised or earned,” said Mark J. Ugoretz, president of the ERISA Industry Committee, which represents the nation’s 125 largest firms.
Sen. Howard Metzenbaum (D-Ohio), chairman of a Senate subcommittee that oversees pension matters, vowed to scrutinize the pension transfers to pay health benefits. In the coming year, Metzenbaum, the Senate’s chief pension watchdog, also expects to examine whether the Department of Labor is doing a good job of enforcing pension laws to protect workers and retirees.
