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Shocker: Huge Companies Cost U.S. Billions Exploiting Tax Break Designed for Farmers Swapping Horses

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Lu Ann Pelle
Lu Ann Pelle

I don't know whether to laugh or cry over this one, folks. From Monday's NYT:

It began more than 90 years ago as a small tax break intended to help family farmers who wanted to swap horses and land. Farmers who sold property, livestock or equipment were allowed to avoid paying capital gains taxes, as long as they used the proceeds to replace or upgrade their assets.

Sounds reasonable, right? Why should farmer Joe or Jane have to pay capital gains taxes every time they sell a horse or piece of land, especially on what amounts to a temporary gain being put right back into the family business? To be fair, if they had to pay on each sale or exchange, these farmers would have been taxed out of business pretty quick. Fine, fair enough.

But, as always with tax laws, if there's an inch of daylight (or less), some rich people and corporations will look to drive a tractor right through it (sorry for the mixed metaphor, I'm doing my best here). According to the reporter's research, now this tax provision is being taken advantage of by corporations, real estate moguls, art investors, you name it.

[This tax provision] provides subsidies for rental truck fleets and investment property, vacation homes, oil wells and thoroughbred racehorses, and diverts billions of dollars in potential tax revenue from the Treasury each year.

According to the article, the Treasury Department estimates that these "like-kind exchanges" cost the government $3 billion per year, but notes that other calculations suggest the number might well be "far higher."

Even worse, this tax provision appears to be encouraging sprawl and driving up the price of farmland because it gives an extra incentive for farmers to sell their land to real estate developers and then move their farm to other, less commercially desirable areas, all without paying capital gains taxes on the initial sale of land. Farmers might do this anyway, but why should they not pay taxes on profits from a real estate deal? No one is excited to pay taxes, but it's a zero sum game: if someone doesn't pay, other people have to make up the difference.

Beyond that it's ridiculous that huge corporations or speculators should be able to take advantage of this provision, buying one investment property, flipping it, and then "replacing" it with another, ad infinitum, not paying capital gains taxes on the sales. This offers a significant advantage to real estate investment over other kinds of investment, such as someone investing in a startup company. Why should that be the case?

The heart of the provision is that the taxpayer, in order to not pay capital gains taxes on the initial sale, cannot have control of the money during the time after the initial sale but before the subsequent purchase takes place, the one that "replaces" the land or property (or horses!) sold in the first. The money from the first sale must go into an escrow account that is under the control of someone else (i.e., not the seller). I read that and thought, OK, that is sort of reasonable for a farmer or small business, at least if the person pays taxes on any interest earned while the money is in escrow. But a big company or speculator still shouldn't be able to do this and avoid capital gains taxes.

However, it's apparently not enough for some big companies to have this benefit without having some access to the money while it's in escrow, even though that is forbidden by law. A subsidiary of JP Morgan recently went on trial for allowing account holders various kinds of access to the money from these sorts of sales while the funds were supposed to be in escrow. The companies that got access to their funds included: Wells Fargo, GE, and American subsidiaries of BMW and Volkswagen.

The JP Morgan subsidiary (since sold by Morgan) was not convicted of any criminal charges, but the IRS is still reviewing some of the companies that had the accounts, is auditing several of them, and could well find that the companies owe back taxes and penalties on these funds.

From reading the article, it's clear that these companies had access to the money (one used the funds as collateral to establish a line of credit, for example, even though the company by law wasn't supposed to be able to draw on the funds). Even without a conviction in the trial, we can see that these companies were taking advantage even beyond "normal" boundary-pushing. The Morgan subsidiary benefited by offering these "advantages" and thus getting more clients to park their money with them as a result. Win-win, right?

Finally, the broader problem with all these tax expenditures is that it's virtually impossible for the U.S. government to truly know whether the law is being followed or whether people are just evading taxes, adding to our national debt, and preventing us from investing in things like education:

The tax break also exposes one of the greatest vulnerabilities of the United States tax system: it depends on voluntary compliance. The I.R.S. staff is so outnumbered by tax lawyers and accounting departments at major corporations that there is often little to prevent taxpayers from taking a freewheeling approach to interpreting and administering the rules.

As long as we have an immensely complicated tax code, one that the I.R.S. simply can't keep up with, there is going to be an incentive or even a necessity to push the boundaries, to cheat. If one's competitors are doing this, then each business has to choose between doing it also or being less profitable than their competitors. Over time, the cheaters will win and the honest business owners will suffer or even go out of business. But we, the people, will also lose.

We need progressivity in the tax code. But we also do need a simpler tax code, one that cannot be gamed so easily. Additionally, we need the I.R.S. to have the funds necessary to enforce the code so that cheaters, especially those costing our government big money, decide it's not worth it to try.

Big money has got all their lobbyists fighting to keep making the tax code more byzantine, filled to the gills with expenditures that, in too many cases, have no larger benefit or aren't being used in the limited way they were intended.

We've got to fight for us, for the common good, because they are taking the money from us. It may not be the sexiest cause, but tax simplification, done in a way that is consistent with larger progressive principles of tax fairness, has to be a major part of what we fight for.