PolicyLast November, Senate Finance Committee Chairman, Max Baucus, released the third package in a series of “Staff Discussion Drafts” proposing various changes to reform the Internal Revenue Code.  Of course, it is likely that any major changes to the Code will be shelved until the inevitable discussion begins regarding the difficult process to address federal tax revenues, the costs of federal programs, the U.S. budget deficit and the burgeoning national debt.

Whether Congress delays action until after the midterm elections in 2014 or (worse) until after the next Presidential election in 2016, the current set of tax rules and federal spending are not in harmony.  In this author’s opinion, with apologies to those economists who believe otherwise, a healthy U.S. economy cannot be maintained over the long term if the United States government continues to operate at a fiscal deficit, carrying over $17 trillion of national debt (and growing).

When the day of reckoning arrives, and Congress finally takes on the unenviable task of balancing the federal budget (much less, making any inroads on the national debt), there will be a mad scramble for “revenue raisers”.   No doubt there will be a plethora of untested ideas, some of which will be enacted.

Last November’s Staff Discussion Drafts included a proposal to repeal Section 1031, which for many years has permitted tax-free, like-kind exchanges of real estate and certain other types of property held for productive use in a trade or business or for investment.  Also included were proposals to lengthen the “cost recovery periods” for depreciable real property and improvements, and to provide for full recapture (at ordinary income tax rates) of depreciation deductions upon sale or exchange of any real property.

If such proposals were enacted, real estate investments would be less attractive, because (i) taxes would have to be paid whenever the form of investment changed; (ii) depreciation deductions would be decreased (i.e., more of the net cash flow from rental income would be income-taxed); and (iii) the tax costs upon a sale would be increased (due to the change in depreciation recapture rules).  These changes would decrease the net after-tax Return On Investment (ROI) that is near and dear to investors’ hearts, thereby making real estate investments marginally less attractive.

From a tax policy perspective, like-kind exchanges traditionally have been permitted on a tax-free basis for a simple, practical reason:  the “seller”, who reinvests all of the “proceeds” in the form of a “replacement property” (a different, illiquid asset), has no cash with which to pay any income taxes on “gain”.  Of course, the real estate investor may be able to borrow against untapped equity value, but (as all who lived through the stomach-churning downturn of 2008-2009 will attest) such borrowing comes at considerable economic risk until/unless the replacement property is sold and the investor truly “cashes out”.

Repealing Code section 1031 might well cause many real estate investors to hold properties longer than they otherwise would be inclined to do, which undoubtedly would slow down the pace of real estate development on a national scale.  Federal tax and fiscal policy should encourage capital investment, including real estate development, to address the ever-changing needs of a population that must adjust to the ever-more-rapid changes in technology, business practices and infrastructure.  Tax-free exchanges provide a significant incentive for real estate investors (i) to “stay invested”; and (ii) to swap properties so that “old” properties can be reinvigorated (and often redeveloped) by new owners.

Hopefully, the proposed repeal of tax-free, like-kind exchanges (and the proposed changes to depreciation rules to make real estate investments less attractive) will be “dead on arrival” when Congress eventually gets around to negotiating its “grand bargain”.  However, there will be no escape from higher levels of federal taxation (in one form or another) over the next decade, so we all should expect to see a large number of proposals that would eliminate or diminish tax benefits now available.