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Oct. 5 — Tax attorneys would like people to stop using the term “loophole” to describe common real estate practices that have come to the forefront since the release of Donald Trump's 1995 state tax returns.
Trump's returns were a topic of discussion during the Oct. 4 vice-presidential debate where the Republican candidate's running mate, Indiana Gov. Mike Pence, said the leaked information shows that Trump “faced pretty tough times 20 years ago” but used the tax code in the way it was intended to be used. The New York Times, when it released the returns, said the $916 million that Trump claimed in net operating losses could have allowed him to avoid paying federal income tax for up to 18 years.
In response to the outrage over the returns, former presidential hopeful Sen. Bernard Sanders (I-Vt.) in an Oct. 4 news release announced that he would introduce legislation in the next session of Congress to “fix our rigged tax system and close loopholes Donald Trump used to possibly avoid paying federal income taxes for nearly two decades.”
“Special tax breaks and loopholes in a corrupt tax code enable billionaires and powerful corporations to avoid paying their fair share of taxes while sticking the burden on the middle class,” Sanders said. “It's time to create a tax system which is fair and which asks the wealthy and powerful to start paying their fair share of taxes.”
The senator's plan would focus specifically on the real estate exemption from the passive loss rules under tax code Section 469, the exemption from the at-risk rules under Section 465, like-kind exchanges under Section 1031, and current debt and depreciation provisions.
Sanders' pledge is part of a larger debate on the future of a tax overhaul and topics that will come to the forefront as a new presidential administration prepares to replace the old.
Gerald V. Thomas II, a partner at McGuireWoods LLP, said he doesn't see most of these measures moving forward into 2017. But on the proposals, he said the plan to repeal like-kind exchanges may have “legislative legs” because it already has some support on Capitol Hill.
Thomas, who specializes in complex transactional tax matters and real estate, didn't deny that Sanders is right in saying that investments in real estate receive certain exemptions, but he said calling the use of those benefits a “tax loophole” is unfair. “These are laws that have been in place for a number of years.”
Other practitioners echoed this argument. David E. Franasiak, a principal at Williams & Jensen PLLC, said Sanders' proposal seeks to eliminate provisions that are legitimate. “They're not loopholes,” he told Bloomberg BNA in an Oct. 5 interview.
Congress intentionally enacted the provisions, Thomas added. And at the end of the day, these benefits encourage economic growth, he said. Specifically, with respect to the exemption from the passive loss rules, “being able to offset real estate income or real estate losses against other income encourages investment in this area,” Thomas said.
In response to arguments that these provisions aren't loopholes, Josh Miller-Lewis, a spokesman for Sanders, said the senator realizes they are part of current law but is aiming to make the tax code more egalitarian. “It’s been well-documented that these tax breaks are overwhelmingly benefiting wealthy Americans like Donald Trump,” he said Oct. 5.
Franasiak, whose firm represents the Federation of Exchange Accommodators, was particularly troubled by the senator's focus on Section 1031 like-kind exchanges. “It’s good policy. It promotes economic growth. It promotes jobs,” he said.
Section 1031 has been a part of the Internal Revenue Code since 1921, he said, adding that while the code section has gone through numerous revisions, it’s been retained because of its effectiveness and ability to help small and medium-sized businesses grow.
Franasiak pointed to several studies that have evaluated the impact of 1031 exchanges on the economy. In a 2015 study, David C. Ling, professor of real estate at the University of Florida's Hough Graduate School of Business, and Milena Petrova, an assistant professor in real estate in the Whitman School of Management at Syracuse University, said repealing like-kind exchanges would increase taxes for thousands of commercial property owners, reduce property values, increase rents and result in a decline of real estate activities.
Charles T. Nunnally III, a shareholder at Chamberlain, Hrdlicka, White, Williams & Aughtry, said he also doesn't agree with like-kind exchanges being characterized as a tax loophole.
“It’s a tax deferral because you’re reinvesting the proceeds and if you don’t reinvest all of the proceeds, you have to pay tax on it,” he told Bloomberg BNA Oct. 5. It's not a form of tax avoidance as described in the news release, he said. Thomas expressed a similar sentiment.
However, Reed Shuldiner, the Alvin L. Snowiss professor of law and co-director of the Center for Tax Law and Policy at the University of Pennsylvania Law School, took an opposing view.
“Most academics—I would predict—would think that rule really is a loophole and doesn’t belong in the code,” he said in reference to Section 1031. In the area of real estate, the provisions on like-kind exchanges have been “very generous,” he said in an Oct. 5 interview.
“Normally I invest in something and I don’t have to pay capital gains until I dispose of it, but now I’m disposing of this property and as long as I swap it for similar property, I still don’t have to pay tax on the gain,” he said. “It gets deferred until I dispose of the new property, assuming I don’t do another exchange or die holding it.”
When that benefit is combined with the step-up in basis that occurs at a decedent's death, it “gives people an opportunity to never pay tax on gains,” Shuldiner said.
Nunnally said such would be the circumstance with any appreciated property whether a Section 1031 exchange occurs or not. Additionally, at death the decedent's estate would be subject to estate tax on the property if it's worth more than the current exemption threshold of $5.45 million, he said.
Thomas and Shuldiner agreed that a provision opposing like-kind exchanges is the most likely—of the four areas mentioned by Sanders—to have “legislative legs” heading into 2017.
Support already exists in Congress for legislation against Section 1031 exchanges. In his 2014 tax overhaul proposal, former House Ways and Means Chairman David Camp (R-Mich.) included a measure to repeal Section 1031 like-kind exchanges.
President Barack Obama's latest revenue proposal would place a $1 million limit—indexed for inflation—on the amount of capital gain that an individual taxpayer can defer in a taxable year. Thomas said he anticipates that Sanders may endorse Obama's proposal in his legislation because he's done so in the past on other policy issues. But the exact details of what his legislation would include weren't provided in the Oct. 5 news release.
At the same time, lobbyists are working to keep the tax code section intact. In an Aug. 1 letter, the Like-Kind Exchange Coalition urged Barbara Angus, chief tax counsel of the Ways and Means Committee, to retain an unlimited amount of capital gain tax deferral. Similarly, in a Sept. 9 letter, the Federation of Exchange Accommodators, joined 25 other real estate and conservation groups in urging Democratic presidential candidate Hillary Clinton to preserve the tax treatment of 1031 exchanges.
Whether the debate on like-kind exchanges will become more prevalent in 2017 and beyond will depend largely on which candidate is elected president, Franasiak said.
“I think the question is: ‘Are we going to have fundamental tax reform?' ” he said. If there's a Donald Trump presidency with a Republican Senate and House, “I think you'll see a big push on tax reform,” he said. However, if Clinton becomes president and Democrats control either the House or the Senate, it's less likely that there will be “full-scale” tax overhaul effort, he said, though tax rates may change.
Altering or eliminating the other provisions mentioned in Sanders' news release—outside of like-kind transactions—would have repercussions beyond the areas of the tax code he is trying to address, Thomas said.
Policy makers should be especially wary of the last subject area—on the treatment of debt and depreciation, he said.
Sanders is right, Thomas said. “You can borrow money, make an investment and take a deduction on the purchase price of the investment.” But any problems that occur with those deductions relate more to how money is loaned, rather than issues with the tax code, he said.
Thomas said he doesn't see that specific proposal going anywhere. “If you take that away, you’re going to cripple the economy,” he said. If that is removed, an individual would only get depreciation deductions for investments he or she makes with equity, he said. “That’s not business. Business uses equity and debt.”
Altering that provision would constitute a “massive change” to the tax code, Shuldiner said. “It’s not something you want to do without really thinking it through. And you could easily overshoot in the other direction and make a rule that’s uneconomic and harsh as opposed to merely neutral.”
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Text of the 2015 study, “The Economic Impact of Repealing or Limiting Section 1031 Like-Kind Exchanges in Real Estate,” is at http://src.bna.com/jbY.
Copyright © 2016 The Bureau of National Affairs, Inc. All Rights Reserved.
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