What’s going to happen to 1031 exchanges in 2010?

by Gary Gorman founding partner, 1031 Exchange Experts, LLC

It seems like every client I talk to wants to know the answer to that question. With some people there’s a growing sense of panic over what that answer might be. They’re eagerly trying to sell their property in what’s clearly a buyer’s market at a time when tax rates are low but are bound to go up. Their worst fear is that their sale will close next year, but at this year’s low price, and after higher tax rates kick in, and after a repeal of Section 1031. In other words, they worry that their smallest possible profits will be eaten up by the largest possible taxes.

Before entering the 1031 industry, I began my career as a CPA, rising to tax manager at one of the “Big Eight” CPA firms. So with that background, and because of the contacts I’ve maintained in the tax industry, I’ve always had a good feel for what the IRS was thinking and where tax legislation was headed.

That is, until now.

What Will Obama Do?
No one in the tax industry I talk to has any confidence in their feel for where the Obama administration plans to take tax law. We all know that the government has spent a lot of money with the Stimulus Bill. As I write this, Congress is struggling to pass some type of healthcare legislation, as well as a so-called Cap and Trade legislation. I won’t even try to speculate if either of those efforts will become law. But it’s clear to me that the Obama administration has grand plans for re-structuring America. All their plans involve spending a lot of money, and that will result in higher taxes for everyone. I sense they haven’t focused on tax law changes yet because they’re focusing all their energy on their legislative agenda right now. But by the end of the year I think we’ll have a sense for what legislation will pass and what it will cost. At that point they’ll turn their focus on how to pay for it.

Capital Gains Tax Will Likely Rise
Starting with the assumption that taxes are going to go up next year, let me go out on a limb and predict what might happen. First, I don’t think it will surprise anyone to see capital gains go up. Obama said during last year’s campaign that he planned to raise long-term rates from the current 15% rate to 20%. In one speech he even suggested a 25% rate. Joe Biden used a 30% rate in a couple of his speeches. Regadless, it’s going up, so we can anticipate the new rate will be at least 20%.

Depreciation Recapture Will Be The Big (but hidden) Tax
When you sell real estate you actually have three taxes to deal with: 1) the capital gains tax, 2) the appropriate state taxes, and 3) the tax on depreciation recapture (currently at 25%). The recapture tax is actually a capped (or maximum) rate, meaning that you recapture the depreciation you’ve taken on the property at your current tax rate, with a maximum rate cap of 25%.

Most everyone knows that the current capital gains rate is 15%, but many don’t realize that they also have to recapture depreciation when they sell a property. I predict that they will not only raise the capital gains rate to at least 20%, but that they will completely remove the cap on the recapture rate. At the current maximum individual tax rate of 35%, this would be a substantial increase, but I expect the maximum individual rate will be raised as well (to 40% or more). The end result will obviously be a very substantial increase in the tax costs of transferring property. In the past when they’ve adjusted the recapture tax it has gotten virtually no press, so you’ll have to dig hard to find out its status in any of the proposed tax bills.

The Future of 1031 Law
I’m sure you’re thinking that this will drive a lot of sellers to 1031 exchanges, and I would agree with you. So in all of this, what does the future look like for 1031 law? While admitting I still don’t have a good read on how this administration thinks, I don’t anticipate that they will do away with Section 1031.

The IRS has list of social tax legislation that reduces tax revenue (things like the charitable contribution deduction, the deduction for personal residence interest, and of course, the deferral of tax on 1031 exchanges).

If I remember correctly, I think every president since Eisenhower has reviewed the items on this list as potential sources of revenue. They’ve all concluded, based on CBO calculations, that deleting Section 1031 would actually reduce tax collections rather than increase them. This may seem counterintuitive, but consider the logic: you might think the government loses tax revenue from 1031 exchanges, but the truth is that many, maybe even most, real estate transactions wouldn’t happen at all if the seller was looking at a large tax bill as a result of the sale. I’m comfortable believing that an updated set of calculations will lead to the same conclusion. What I don’t know is: will this administration care about the impact; or are they more focused on their social agenda?

Possible Alternative Modifications to Section 1031
Alternatively, might they modify Section 1031 as a way to raise revenue? One area affecting real estate they could tweak that might impact collections would be to impose a two-year holding period in order to do an exchange rather than today’s one year period. We handle a lot of exchanges where the property has been held for less than two years.

Another tweak might be like the one proposed by the Clinton administration: narrowing the definition of “like-kind.” Meaning that if you sell an apartment building you have to buy another apartment building. As it stands now, the definition of “like-kind” is more generous to taxpayers. Right now, an apartment building is ‘like-kind’ to bare land, to a restaurant, to a warehouse, to an office building, to a rental house, a factory, a farm, etc. The Clinton proposal went nowhere, but this administration might try that proposal again.

The one big change they could make which would materially impact tax collections would be to do away with exchanges of personal property. “Personal property” in 1031 exchanges are things that move, like cars, trucks, trains, planes, construction equipment, etc. It might surprise some people to know that as a percentage of tax revenue deferred by Section 1031, real estate represents only about 40% of those dollars, while personal property represents the majority at 60%. For example, all the rental car companies (Hertz, Avis, National, etc.) use 1031 exchanges as they rotate their fleet, as do the companies that finance leased cars. Since rental car companies don’t vote, the administration may figure there won’t be much in the way of political cost in a change like this. On the other hand, companies like this have a lot of money to spend on lobbyists.

I hope I’ve given you a few things to keep your eye on in 2010. If you’re a real estate investor or a real estate profesional, you should save this article. It will give you something to watch for when Congress starts drafting tax legislation.