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Looming tax hikes Jan 1, 2013 sparks renewed interest in 1031 exchanges

Given the uncertainties flowing from the elections and a lame-duck Congress getting set to play chicken with the "fiscal cliff," it is no surprise that a growing numbers of real estate investors are taking a new look at Section 1031 tax-deferred exchanges to defer capital gain taxes by reinvestment into qualified investment properties

I recently spoke with the owner of a major title company here in Austin and he told me that they have seen a significant increase in interest in exchanges recently -- 30 to 40 percent higher volume year over year, he told me. Part of the reason, he said, is rising real estate investor concerns about much higher tax bills ahead, with Obama remaining in the White House.

"We've seen a tremendous spike in 1031 transactions (in light of) election year uncertainty over the future of capital gains taxes. The political brinksmanship in Washington over extending or ending Bush-era tax cuts has left investors in the funk. ..."

What sort of brinksmanship and at what cost? Well, start with the fact that after Dec. 31, if the lame-duck Congress does not act with uncharacteristic bipartisanship and speed, capital gains taxes will jump to 20 percent on Jan. 1, up from the current 15 percent. The highest marginal tax rate for ordinary income will also increase, from the current 35 percent to 39.6 percent.

Then there's the 3.8 percent Obamacare surtax on investment income scheduled to kick in for high earners ($200,000 adjusted gross income for single filers, $250,000 for married joint filers) on Jan. 1. Since many real estate investors and a sizable number of homeowners fall into this income category, a lot of people will be looking at capital gains taxes of 23.8 percent next year -- a 58.6 percent jump over what they're paying today.

For residential and commercial real estate investors,I spoke with an attorney friend specializing in personal financial services and tax consulting with national accounting firm Ernst and Young, Section 1031 now "is worth doing the calculation: Do I rush to sell property in the closing days of 2012 and pay a 15 percent capital gains rate or do I begin planning to defer taxes with a 1031 exchange in 2013, assuming the worst?"

Section 1031 has been part of the federal tax code for decades. It allows the seller of an investment or business property to postpone recognition of gain provided the seller acquires another, "like-kind" property within the timing requirements spelled out in the law.

By eliminating capital gains taxes from the transaction proceeds, property sellers increase their purchasing power. With the money that would otherwise have gone to the IRS, they have more to reinvest in a bigger, perhaps higher-income-earning replacement property.

Consider this hypothetical case example prepared by First American Exchange Co., a subsidiary of First American Title Insurance Co.: Say you purchased a rental property for $100,000 many years ago, which now has a mortgage balance of $50,000. You've made no capital improvements to the property in the meantime, but have taken $50,000 in depreciation deductions.

Now you want to sell the building for $200,000. If you simply sell it and choose to pay capital gains at current rates, you'd owe $12,500 in depreciation recapture (which is taxed at 25 percent), $15,000 in capital gains taxes (at 15 percent), plus whatever tax your state levies on capital gains. For the purposes of this example,  the latter rate is 5 percent ($5,000), but it can go much higher in states such as California. So simply selling conventionally under today's tax rates, you'd owe $32,500. After paying off the mortgage balance, you'd have net proceeds of $117,500 to invest somewhere.

If you instead structured the transaction as a tax-deferred 1031 exchange, you'd pay zero in federal or state taxes, and have $150,000 in cash available to acquire a bigger and better new income property, whether another residential building, commercial or retail real estate -- the potential range of choices is vast under the law.

Say you were able to obtain mortgage financing of 75 percent on the replacement property -- you could use your $150,000 cash in hand to make the down payment on a $600,000 building. Had you gone the conventional tax route, your $117,500 in proceeds would have limited you to acquiring real estate worth just $470,000.

Now fill in next year's potential rates: 20 percent capital gains, 3.8 percent health care surtax. The costs of a standard sale go up dramatically, and the cash you have to acquire bigger and better real estate declines dramatically.

Sure there are a few downsides to 1031 -- it is, after all, a deferral of taxation not a forgiveness, and at some point down the line you or your estate will probably have to reckon with the IRS and pay taxes at rates that are currently unknowable. Similarly, when you do a 1031 exchange, you move your tax basis to the replacement property and that cuts your depreciation deductions.

But bottom line, many real estate investors are beginning to do the calculation, and are finding that 1031 is looking better and better.

  1. LillyRealtorLillyRealtor12-15-2012

    If you are thinking of a 1031 exchange, be sure to shop around for the (I forgot the term) who does the exchange. Costs vary greatly. And, keep in mind, as the bloggers states, that it is a deferral of taxes that will eventually be paid one day at who knows what rate.

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