A Disconcerting Proposal From The Senate: Proposed Repeal Of Section 1031

Last 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...