Just about everybody who owns or invests in income real estate knows how important tax-free "Section 1031" exchanges are. After all, Section 1031 of the federal tax code allows investors to swap "like kind" properties without having to pay Uncle Sam the hefty capital gains taxes they'd owe if they simply sold their real estate.

What you may NOT know is that tax reformers on Capitol Hill -- green eyeshade types on Congressional committees who spend all their time trying to figure out how to squeeze more money out of ordinary citizens -- have been trying to limit property owners' ability to do exchanges.

The most recent attack is still underway: A bill that's already passed the Senate would narrow the definition of "like kind" in certain agricultural real estate transactions -- forcing potentially large numbers of farmers to sell, rather than exchange, their properties and pay high capital gains taxes that they'd currently be allowed to defer.

Why does that matter to investors in other types of investment real estate? Why should rental home investors or owners of apartment buildings or commercial property even care?

Here's why: Because ANY narrowing of the definition of "like kind" for real estate amounts to the proverbial 'camel's nose in the tent.' It's just the beginning of a much larger, sustained attack.

Ultimately tax reformers want to rein in real estate exchanges by imposing strict rules allowing rental houses to be swapped ONLY for rental houses, investment land to be swapped ONLY for investment land, office buildings only for office buildings and so forth.

Under long-standing rules, owners currently can do tax-free exchanges on virtually any form of income-producing or investment real estate: A resort rental condo in Hawaii could be exchanged for farmland in Iowa, for example; an apartment building in Texas could be exchanged for mineral rights in Colorado or a retail strip in New Jersey.

That sort of flexibility would be chipped away by an obscure section buried deep in the Senate's massive farm bill for 2008, which is awaiting a conference with House negotiators.

Lobbyists from the National Association of Realtors are on the case -- and may well be able to convince Congress to back off. But investors who use -- or plan to use -- a 1031 exchange to defer capital gains taxes need to be aware of it -- and should let their Congressional representatives know how they feel.

Published: February 4, 2008

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Kenneth R. Harney writes an award-winning, nationally-syndicated column on housing and real estate from Washington, D.C. He is also managing director of the National Real Estate Development Center, a professional education company. He is a past member of the Federal Reserve Board's Consumer Advisory Council, a committee that by federal statute reviews all Fed actions on home mortgage, consumer credit and banking industry regulation. He served as a member of the U.S. Department of Housing and Urban Development's Working Group on Computerized Loan Origination (CLO) systems, and is a member of the Editorial Board of the Fannie Mae Foundation's journal, Housing Policy Debate. He is the author of two books on mortgage finance and real estate.