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Tax reform is needed, but be careful where you cut

Tax reform is needed, but be careful where you cut

There are major concerns with part of the tax reform proposal now being considered in Congress.

Editor’s Note: David Fisher is managing member of ExchangeRight Real Estate in Ankeny, Iowa.

There is a move afoot in Congress to reform taxes. It is now apparent from discussions I have had with several groups and advisers that House Ways and Means Committee Chairman Brady’s Tax Reform Blueprint would completely eliminate Section 1031 and also disallow all business interest expense and these tradeoffs would allow the immediate expensing for all business investments in equipment, buildings, etc.

FARMS WOULD BE HURT: Small businesses, farmers, real estate investors and new businesses that need debt capital to grow their businesses and provide jobs would be hurt significantly if Section 1031 Exchanges and business interest expense deductions are eliminated from U.S. tax code.

While I generally applaud work on tax reform, I have major concerns with this part of the proposal. As this article explains, there are eight good reasons to keep business interest expense deductions and Section 1031 Exchanges in the U.S. Tax Code.

Small businesses, farmers and others need interest deductions and Section 1031
From my analysis of these provisions, the largest corporations with lesser need to finance their businesses with debt capital will be huge winners. Apple for example has almost no interest expense and a 10% drop in tax rate would save them $3 billion in first year based on their last financial statements: this is without assuming any benefit to them of immediate expensing.

Small family businesses, farmers, real estate investors and new businesses that need debt capital to grow their businesses and provide good jobs will be hurt significantly.

1031 exchange has been available for nearly a century
The 1031 exchange concept has been available to investors in the Tax Code since 1921: nearly a century. It has remained a part of tax law through various major tax reforms. The reason it has survived is because it is a very good tax policy as it encourages reinvestment which drives economic growth and is built on the principle of not taxing gains until they are realized by the taxpayer.

My partners’ and my businesses employ approximately 50 people and our Iowa headquarters is in Ankeny. Most of these positions would be eliminated if Section 1031 was eliminated from the tax code. I know people in the qualified intermediary business who service investors doing 1031 exchanges. All of those businesses here in Iowa and across the nation will immediately go out of business if Section 1031 is repealed.  

Don’t eliminate business interest expense deduction
The elimination of business interest expense deduction would be devastating to many Iowa farmers and small businesses as well.  The benefits of lower business tax rates and “immediate” expensing proposed in Brady’s tax plan will not be nearly enough for many to offset this lost deduction. We modeled our own business based on 2015 numbers and our effective Federal only tax rate would have been 44% under the new plan (assuming 25% tax on our business taxable income). 

This is because ExchangeRight uses borrowed capital to acquire real estate assets and then turns around and resells them to investors doing 1031 Exchanges. Financing (and thus interest expense) is a very important part of our business model and cost structure.

Farmers (like my semi-retired 87-year-old father) rely on operating financing and need to be able to take tax deductions for that interest cost. Businesses like car dealers rely on interest expense deductions to carry the inventory they need to run their businesses.      

Big holes in the currently proposed legislation
Brady’s team has informed real estate industry professionals that immediate expensing of real estate investments with loss of interest expense deduction will offset the lost economic value of having Section 1031 exchanges. There are many holes in this concept:

1.      Land is left out in this concept -- landowners like farmers, real estate developers, etc. would no longer have incentive to reinvest in new land; this will slow growth and development.

2.      Every real estate transaction includes a component of land thus the IRS would immediately look to challenge the portion of each and every new real estate investment and classify more as land thus limiting the immediate “expensing”

3.      Farmers, investors and all who have owned real estate for a long term will be hurt badly. They have low basis to “roll” into a new investment and get an “immediate expense” for. If they sell they will just have gains, and thus economic activity is likely to be materially slowed as a result. Whether they sell or hold; they are giving up the interest expense deduction from holding real estate. Thus they get no benefit from the immediate expensing; they lose the chance to do future 1031 exchange and lose their interest expense deduction.

4.      Current 1031 provisions allow taxpayers to sell an asset in one tax year and reinvest within 180 days and this often crosses over tax years. The current blue print “immediate expensing” would have to be completed within the same tax year. This will mean that real estate buyers will be inclined to delay new purchases until late in the year and sellers will not want to sell late in the year because they will not have time to reinvest. This would create a very imbalanced real estate market.

5.      Long-term holders of real estate investments will have a significant increase in effective tax rates. Example:

 

6.      If tax reform trades away Section 1031 and business interest expense for “immediate expensing” of real estate assets (and other assets); then this area will become the first place a future Congress will attack to raise revenues. Once power is flipped, the opposition will push to go back to a more normal (and frankly logical) depreciation approach; however, Section 1031 and business interest expense will already be gone and will not likely come back into law –- EVER.

7.      Elimination of interest expense deductions will cause younger farmers and business owners to either not be able to start business, require them to remain renters and/or drive them out of business. Borrowed capital is the life blood of new businesses and young farmers. Having young farmers remain renters leaves the land wealth of Iowa in the hands of investors instead of in hands of people who live and work on the land. The same will be true of other businesses that have to make difficult capital deployment choices and for many this will mean never getting started.

8.      Below are examples of why the loss of interest expense is potentially so damaging to capital intensive businesses (especially land or inventory intensive businesses that will not benefit from immediate expensing). There will be years where effective tax rates on farmers will be more than 100% without the ability to deduct interest expense.  This could additionally put farmers in an already difficult year of not having the cash to pay their tax bills. Examples:

The largest corporations with lower leverage ratios and wealthiest Americans in the country will of course benefit greatly from Brady’s plan with reduced tax rates and immediate expensing. Those same corporations will also pay the best professionals to find ways to economically still get their “interest expense” deductions. They will do this through offshore companies, preference share issuances, JV entities, partnership entities and a myriad of other structures yet to be designed.

This is not a guess on my part. I KNOW this will happen because I spent over 20 years of my career as someone who did that exact kind of tax planning; utilizing the tax laws to get the best possible outcome for my large employers and large corporate clients. Big corporations will find ways to work around the interest expense deduction issue.

Does this mesh with President-elect Trump’s tax plan?
President-elect Trump’s plan does not have a concept of immediate expensing for buildings (only equipment) and it seems unclear as whether loss of interest expense deductions in his plan would include interest associated with real estate investments. What is clear is that the House will drive the ultimate process and it is highly unlikely that Trump will stand in the way if the reform plan includes major themes he wants: like lower corporate and personal tax brackets.

My other major concern is the danger of the economic experiment with the U.S. economy. Section 1031 has helped fuel re-investment in the U.S., and business interest expense deductions encourages people to create jobs and take on new business ventures. What if the theory model behind Brady’s plan is wrong and instead of driving growth, it immediately puts a strain on real estate values, results in thousands or hundreds of thousands of immediate or near-immediate job losses and drives a recession. Large corporations will benefit under his plan and likely come out very well but it is small businesses and investors who really drive the growth in the economy and I believe this experiment will put many of them at risk.

SUMMING UP: Hopefully, once taxpayers get fully informed on this issue they will see as I do that immediate expensing (at least for real estate), coupled with loss of business interest expense deductions and the death of the 95-year-old Section 1031 should not be a part of the tax reform bill. Join me in taking action with your own communication to Congress and/or via our website savethe1031.org.

David Fisher is managing member of ExchangeRight Real Estate in Ankeny, Iowa. Visit his website exchangeright.com. You can contact him at david@exchangeright.com.

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