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Wharton Emeritus Professor Dr. Peter Linneman explains how they came to be.
Bruce Kirsch: A 1031 exchange is a specialized type of exit strategy which was created by the Internal Revenue Service wherein one property is exchanged for another. And the capital gains taxes that would have to be paid on a sale of the initial property are in fact deferred until the sale of the second property. What was the impetus behind this relatively complicated option for exit strategies by the IRS?
Dr. Peter Linneman: Like many things, it didn’t start from where it ended up. It started from a very simple that when companies merged I would, quote, “buy your company,” but I pay you by simply giving you a whole bunch of my stock or my partnership interests. So yes, you may have gotten a gain, but you didn’t have any cash. You just had paper that said acquiring company on it instead of the name of your old company on it.
And so people said, gee, when there’s a merger, and I don’t get any cash, I shouldn’t have to pay the capital gains tax until I actually get the cash because all I did was exchange my property for something– my company, my interest, for something just like I got. And I don’t have cash. Cash was not like what I had. And when I get cash, I’ll pay my tax.
And Congress said, yeah, that makes sense to us. And they implemented legislation really geared toward stock companies doing mergers. And then people started saying, wait, wait, wait. Well, what about us? If I exchange in our case property for property, I don’t have cash. All I did was change the name on the paper from building A to building B. And only when I get cash should I then really have to pay a tax.
And Congress said, well, we never thought about that. And you can imagine there was a lot of lobbying, and then they said, OK, but you got to make sure you end up with a like. So if you own your property in partnership, you got to end up with partnership units. Because if you exchanged your partnership units for shares, maybe the shares are more liquid and therefore easier and more valuable. That’s not a like to like.
And the rules and the nuances then begin to proliferate on this relatively simple idea that says until you get cash, you don’t pay a capital gain. But the actual law then becomes incredibly complex and nuanced. And what’s really happened in real estate and in other areas is that very rarely do I say, Bruce, you give me your property. And I’ll give you mine. And it’s a true exchange. It’s very rare that.
More typically, what happens is it says, I’m going to sell my building. But give me a few days. And I’m going to roll that money right into another property that’s pretty much like it in terms of its illiquidity and its risk and its value. And therefore, wait a minute. Since all I did was exchange one asset for another, yes, there may have been cash in between for a few days. But that was just kind of a coincidence.
Most like-kind exchanges in real estate actually involve cash but in this temporary sense in a highly legislated and regulated sense where if you don’t want to pay taxes, it’s highly nuanced as yes, that can’t be cash very long, and you have to turn it back into an ownership position that’s fairly similar to what you had before you sold and got cash. Confusing, complex, and expensive all designed to postpone paying capital gains taxes, particularly if you’ve taken a lot of depreciation over the years. That’s always bothersome because I could be selling a property even at a loss in some cases.
But if I’ve taken enough depreciation, I could have a capital gain due. And people say, wait, wait, wait, I didn’t make any money. I don’t want to pay capital gains taxes. I’ll do a tax-deferred exchange. A lot of times, people end up giving up the value of not paying taxes by paying more for the property because they’re under tight timelines. And it’s not so easy to be done, but it is doable.