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.
Over the years, however, as the rules were loosened, the practice of exchanging one asset for another without incurring taxes spread to everyone from commercial real estate developers and art collectors to major corporations. It 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.
Yet even with those generous terms, some major U.S. companies -- including Cendant, Wells Fargo and General Electric -- have routinely pushed the boundaries while claiming lucrative tax savings, according to evidence recently presented at a federal trial in New York City.
President Barack Obama and congressional leaders agreed on New Year's Day to a limited agreement to raise taxes on the wealthy, and the president said last weekend that he would press this year for broader overhaul in the tax code. The expansion of the tax break once intended to help farmers illustrates the challenges ahead and how special interests have learned to use the tax code to maximum effect.
The federal government now allows more than $1.1 trillion a year in this and other tax expenditures. Each of those incentives -- which include hundreds of exemptions, exclusions, deferrals and preferential rates -- either adds to the budget deficit or shifts the cost of government to other taxpayers.
Some are narrowly targeted and offer aid to specific industries such as NASCAR owners, asparagus farmers, oil companies, yacht makers or solar panel producers. Others, such as accelerated depreciation or the tax code's preference for debt financing over equity, provide tax benefits for wide swaths of businesses.
"Tax expenditures are very similar to an entitlement program, so they're easy to start," said University of Virginia School of Law professor George Yin, former chief of staff of the Congressional Joint Committee on Taxation. "But once a tax break gets started, people think they're entitled to it, so they are very difficult to end."
Many tax breaks began with narrow targets and expanded into vast, expensive subsidies far beyond their original intent or the Internal Revenue Service's ability to monitor them. Most have developed constituencies of taxpayers, lobbyists and elected officials who fiercely defend them, making it politically treacherous to limit or eliminate them.
With hundreds of thousands of transactions a year, it is difficult to gauge the true cost of the tax break for so-called like-kind exchanges, such as those used by Cendant, GE and Wells Fargo. The official government estimate is that it diverts less than $3 billion a year from the Treasury, but some industry statistics suggest that the number could be far higher.
The tax break also exposes one of the greatest vulnerabilities of the U.S. tax system: It depends on voluntary compliance. The IRS 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.
What's more, the tax break is one of so many that it tends to escape attention. The independent Simpson-Bowles deficit commission appointed by Mr. Obama in 2010 raised the possibility of eliminating it and other tax expenditures, however, and some budget experts argue that the program should be severely limited or repealed.
Some financial planners and economists say the tax break even favors real estate investors unfairly, by allowing them to defer capital gains taxes that those who invest in securities and other ventures have to pay. And although it was originally intended to help farmers, some economists and lawmakers in agricultural areas say it has perversely contributed to the spiraling cost of farmland. Because it allows farmers to avoid capital gains taxes on land swaps, the tax break provides an incentive to sell farmland coveted by developers and buy property in less desirable and more remote areas.
A crucial element of the tax break is that companies cannot use the proceeds of an asset sale for any purpose other than buying a replacement. Because the break is intended to encourage reinvestment in a business, companies that sell an asset are required to deposit the proceeds from the sale into an escrow account, which must be controlled by a third party. If the company has control of the money, the tax break is disallowed, according to tax experts. "Funds cannot be held under the taxpayer's sole control," said David Shechtman, a lawyer who headed the American Bar Association tax committee that oversees the exchanges.
Documents and testimony at the recent federal trial indicate that a subsidiary of one of the nation's largest banks, JPMorgan Chase, stood by for years as the companies -- most of which were also major depositors in the bank -- bent the rules governing these exchanges of property. JPMorgan sold the subsidiary in 2008.
At least a half-dozen companies were allowed unrestricted access, according to evidence at the trial. For at least 30 months, Wells Fargo had unfettered access to billions of dollars intended to be held in escrow, the records show. And U.S. subsidiaries of Volkswagen and BMW had so much control over the money that they used it as collateral to obtain lines of credit.
Wells Fargo spokesman Oscar Suris declined to comment. Volkswagen and BMW officials said they were confident that the companies were in full compliance with tax regulations. Cendant spokesman John Barrows said that company, which is now the Avis Budget Group, had complied with all tax laws and IRS regulations.
JPMorgan's lawyers argued during the trial that the instances in which its clients were apparently allowed to skirt the tax rules had been few, inadvertent and, in some cases, approved by tax lawyers and accountants who worked for the companies. Officials at J.P. Morgan Property Exchange, or JPEX, the subsidiary that handled the transactions, testified that because they were not tax experts, they deferred to their clients' accountants and legal specialists.
JPMorgan said its employees never violated tax regulations. "The court agreed that our firm acted appropriately and that this business complied with all relevant tax laws at the time our firm owned it," said spokesman Joseph Evangelisti.
The largest corporation cited in the case, General Electric, had unrestricted access to nearly $300 million from transactions made by its equipment finance subsidiary from 2007 to 2009, according to testimony, documents and company officials. The money -- which saved GE $3 million to $4 million a year in interest because of tax deferrals, according to company estimates -- was kept in GE's internal computer system, WebCash, which is controlled solely by company employees rather than by an intermediary.
Russell Wilkerson, a managing director at GE Capital, said outside tax advisers had assured the company that its unorthodox arrangement met IRS regulations because it required the approval of the intermediary before any transaction was made. "GE has always executed its like-kind exchange programs in a fully compliant manner, without exception," he said.
Evidence about the questionable procedures was made public as part of a lawsuit filed in U.S. District Court by NES Financial, a California company that acquired JPEX in 2008. NES Financial sought more than $20 million in damages, saying that JPMorgan had failed to reveal the apparent violations before the unit's sale, and that the IRS, which is now auditing several of its clients, could impose millions of dollars in back taxes and penalties on the corporations.
Judge Victor Marrero dismissed the suit, despite evidence that some of the companies were not following IRS regulations. In his ruling in late November, he said NES Financial had not proved that it was likely to face losses.
Several JPEX employees said at the trial that the company had, in some cases, allowed clients access to money that was supposed to be segregated.
IRS officials are reviewing some of the companies that used JPMorgan Chase, according to evidence presented at the trial, though it is unclear which ones. GE said it was not the subject of an inquiry.
Even as the debate over the tax break continues, there is a deep conviction in the real estate business that it is justified. Advocates for the real estate industry say a large majority of transactions are conducted in strict compliance with IRS regulations. Because the asset exchanges spur investment and help create jobs, industry officials say they would strenuously oppose any effort to end them.
"Historically, these exchanges are a very important consideration for a very important segment of the economy," said Jeffrey DeBoer, chief executive of the Real Estate Roundtable. "I have no reason to believe that Congress won't ultimately recognize that."