Billionaire Donald Trump, who built his fortune in real estate, told Bloomberg Politics this week that he wants to raise his own taxes. One way to do it is a bipartisan proposal that would blow up one of the real estate industry's favorite tax breaks.
The break, known as the like-kind exchange or "1031" for the tax code section it comes from, lets real estate owners sell one piece of property and buy a new one soon afterward without paying any capital gains taxes on the profits from the sale. The result is an ever-increasing pile of deferred capital gains, taxed only whenever there is a final sale or, better yet, never taxed as income at all upon death.
"It was originally meant to really cover a narrow set of transactions," said Lily Batchelder, a former aide to Senate Finance Committee Democrats and to President Barack Obama. "It's grown into this huge loophole, especially for wealthy real estate investors."
Obama has proposed curbing the tax break, arguing that the justification for the 94-year-old provision is outdated because each piece of real estate can be easily valued and then taxed when sold. His plan would limit the benefit to $1 million per taxpayer per year, raising nearly $20 billion for the government over the next decade, according to the Treasury Department. (That's more money, by the way, than the carried interest tax break that's gotten much more public attention and criticism from Trump and leading Democrats.) Former top lawmakers in Congress—Republican Dave Camp and Democrat Max Baucus—went even further than Obama, proposing full repeal of like-kind exchanges for real estate as part of their broader plans to revamp the tax code.
The break distorts economic decision-making by making real estate transactions different from others, but it's been a central part of deals for so long that getting rid of it would be disruptive, both to real estate investors and the industry of intermediaries that exists to facilitate property exchanges. Unsurprisingly, the real-estate industry has spent the past two years building a lobbying campaign to justify the break and warn of dire economic consequences if it vanishes. The hand-to-hand combat has occurred mostly behind the scenes in Washington, as lobbyists try to shape a mega-bill on taxes that's going nowhere until 2017 at the earliest. Trump and his company aren't part of the Real Estate Like-Kind Exchange Coalition, according to Jeffrey DeBoer, president and chief executive officer of the Real Estate Roundtable.
"Our tax code is clearly in need of an overhaul, but it should not come at the expense of provisions that fuel economic growth on Main Street," Daniel Goodwin, chief executive officer of Inland Real Estate Group of Companies Inc., said in a statement that called the provision a "core catalyst" for domestic real estate. "A 1031 exchange, for example, enables a business or investor to defer—not dodge—the capital gains tax on an asset sale."
In 2011, U.S. taxpayers deferred more than $33 billion in capital gains through exchanges, according to Internal Revenue Service data. Without the break, they would be more likely to hold onto property, locking themselves into investments for more time to avoid paying the capital gains tax, said Brad Borden, an expert on real estate and taxes at Brooklyn Law School. Property owners would also be more willing to move their investments outside of real estate, because the tax costs of selling for cash and swapping buildings would become equal.
As for Trump, who is leading in polls for the Republican presidential nomination, it's not at all clear what he pays in taxes or how much he benefits from section 1031, because he hasn't released his tax returns. He tends to make long-term real-estate investments, and a good chunk of his income comes from licensing deals that pay him for the use of his name, not necessarily ownership stakes where like-kind exchanges would be an effective strategy. Borden said he'd be "shocked" if some of Trump's entities hadn't used the break.
Still, section 1031 supports the entire real-estate industry, encouraging frequent transactions and creating the environment where Trump thrives. In some cases, it may keep prices lower, because it makes property owners more willing to put their buildings on the market. An industry-backed study released earlier this year said exchanges under section 1031 lead to less debt and that 88 percent of the properties that are exchanged are later sold in taxable transactions. An earlier industry-backed study said repeal would lead to more borrowing and reduce gross domestic product by 0.04 percent.
DeBoer said in an e-mailed response to questions that repealing like-kind exchanges would lower real estate values by reducing liquidity and increasing friction in real estate transactions. “Rather than distorting economic decisions, like-kind exchanges remove artificial tax considerations from real estate investments," he said. "Section 1031 prevents the taxation of phantom income. Any taxable gain must be used to acquire the replacement property, otherwise it is taxed immediately.”
The real estate industry's power in Washington—just think of how well the mortgage interest deduction has survived—will make the tax break tough to dislodge. "It would take some gumption, but it's the right policy call and it's a way to treat different investments fairly and in the same manner," said Batchelder, who now teaches at New York University's law school.
Trump will release more details on his tax plan over the next few weeks, Hope Hicks, a campaign spokeswoman, said in an e-mail. She didn't say whether Trump has used like-kind exchanges.
Of course, there are other, more straightforward ways that Trump can raise his own taxes. He can increase marginal tax rates. He can adopt a favorite Republican proposal and end the tax deduction for state and local income and property taxes, which disproportionately benefits residents of high-tax states such as New York. He could also raise estate taxes or limit the maneuvers the wealthiest few can use to minimize that tax. But Trump thrives on drama, and none of those options would be nearly as dramatic as attacking his own industry.