Congress is always on the hunt for “pay-fors”–tax increases and spending cuts which can be used to offset other tax increases or spending cuts.
Unfortunately, there’s a treasure trove of tax increase “pay fors” in H.R. 1, the “Tax Reform Act of 2014,” which was introduced last Congress by former Congressman and Ways and Means Chairman Dave Camp (R-Mich.) One of these tax hike pay-fors is an elimination of so-called “like-kind exchanges.“
This was the wrong idea, since like-kind exchanges are actually a good model of capital gains tax reform, not a loophole to be closed.
What is a like-kind exchange?
Suppose you are a business owner. You bought a bunch of widgets (business assets, not inventory) a few years back for $1000. You now want to sell these widgets, and have a buyer for $1500. In the normal course of events, when you sell the widgets you would have a capital gain of $500 (the sales price of $1500 minus the purchase price of $1000), and you would pay tax on that capital gain.
But you, the business owner, don’t want to cash out. You want to buy a fresh set of widgets with your $1500. The tax code has a way for you to do that and defer paying the capital gains tax from that first sale. It’s called a “like-kind” exchange. You set up an intermediary trust, which receives the $1500 you get when you sell those widgets. You then have 180 days to purchase a fresh $1500 set of widgets with the money. Your basis in the second set of widgets is the same as your basis was in the first set of widgets.
You can do this as many times as you want, provided the set of widgets you are buying are of a like kind to the widgets you are selling, and provided that you’re using all the proceeds every time to buy more widgets.
Only when you decide to sell out of the widget business and cash out do you actually have a capital gain. The gain is the difference between the final sale amount and the original tranche of widget purchases. The capital gain is embedded over the years in the business, and it becomes due when the business activity effectively ends.
A model for capital gains
All capital gains should work this way. If you buy a stock for $100 and sell it for $150, you should be able to plow that $150 into new stock purchases without having to pay tax along the way. Ditto for any type of capital gain you might have.
You know who agreed with this concept? None other than current Ways and Means Chairman Congressman Paul Ryan (R-Wisc.) Back in 2007, he introduced H.R. 2796, the “Generate Retirement Ownership Through Long Term Holding (GROWTH) Act.” It would have allowed something very much resembling a like kind exchange by default for capital gains generated within mutual funds.
When H.R. 1 decided to take away like kind exchanges (which would be a tax increase of over $40 billion over a decade), it implicitly labeled these sales as “tax loopholes.” Nothing could be further from the truth. All capital gains should work this way, in fact. Imagine investors not having to report each and every stock and mutual fund transaction on their taxes every year, and instead having a deferred capital gain until sale, a kind of brokerage account version of an IRA.
That would not only simplify tax filing for millions of Americans, it also would make all capital markets–for everything–more efficient. Every time the government takes money out of the pool of capital investment, capital grows more slowly and we’re all poorer than we otherwise would be. The key to wealth creation is to leave capital–unmolested by government–free to grow for as long as possible.
Congress should not be looking to restrict like kind exchange plans–they should be looking to do tax reform with them as a model.