“What’s going to happen to 1031 exchanges next year?” It seems that every client I talk to wants to know the answer to that question, and with some people there is a growing sense of panic over what the answer might be. They’re trying to sell their property in a market that is clearly a buyer’s market, at a time when tax rates are low but bound to go up. Their worst fear is that their sale will close next year, at this year’s low price, after higher tax rates kick in and after a repeal of Section 1031 – in other words, they worry that all the cash will be eaten up by taxes.
Before I entered the 1031 industry I started my career as a CPA, rising to tax manager at one of what was then the “Big Eight” CPA firms. As a result of my background, and because of the contacts I still have in the tax industry, I’ve always felt like I 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 I’ve talked to has any confidence in their feel for where the Obama administration plans to take tax law in the future. We all know that the government has spent a lot of money in the Stimulus Bill, and as I write this, Congress is struggling to pass some type of health care legislation as well as the 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, and all of their plans involve spending a lot of money that will result in higher taxes for everyone. I sense that they haven’t focused on tax law changes because of the energy they’re expending 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 its cost will be, and at that point they’ll turn their focus to how to pay for it.
Capital Gains Taxes Will Likely Rise Next Year
So, starting from 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 the elections that he planned to raise them from the 15% current rate to 20% (and in one speech he even used a 25% rate). Joe Biden used a 30% rate in a couple of his speeches, so you can plan on the new rate being at least 20%.
Depreciation Recapture Will Be The Big (but hidden) Tax
When you sell real estate you actually have three taxes you have to deal with: the capital gains tax, the appropriate state taxes, and the tax on depreciation recapture (which is 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 not many realize that they also have to recapture depreciation when they sell a property. I predict that not only will they 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.
The Future of 1031 Law
I’m sure your thinking that this will drive a lot of sellers to 1031 exchanges, and I agree with you – so what’s the future look like for 1031 law in all of this? While I have to admit that I still haven’t got a feel for 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). Every President since, I believe, Eisenhower, has reviewed the items on the list as potential sources of revenue. They’ve all, based on CBO calculations, concluded that deleting Section 1031 would actually reduce tax collections rather than increase them (while your initial impression is that the government looses tax revenue as a result of Section 1031, the truth is that many, or maybe most, of the real estate transactions wouldn’t happen if the seller was looking at a large tax bill as a result of the sale). I’m comfortable that an updated set of calculations will come to the same conclusion, what I don’t know is if the administration cares about the impact, or if they are more focused on their own social agenda.
Possible Alternative Modifications to Section 1031
Alternatively, might they modify Section 1031 as a way to raise revenue? The only area affecting real estate that they could tweak that might impact collections would be to impose a two year holding period, rather than one year, in order to do an exchange – we handle a lot of exchanges where the property has been held less that two years. Also, the Clinton administration proposed narrowing the definition of like-kind to say that you have to buy the same type of property you sold – so if you sell an apartment building you have to buy an apartment building. That proposal went no where, but they might try it again.
The one big change that they could make which would materially impact tax collections would be to do away with exchanges of personal property. Personal property is things that move, like cars, trucks, trains, planes and construction equipment. A fact that very few people know, is that as a percentage of tax revenue deferred by Section 1031, real estate represents only about 40% of the dollars, while personal property represents the majority at 60%. For example, all of 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 that there isn’t much political cost in a change like this. On the other hand, companies like this have a lot of money to spend on lobbyists.
Hopefully this article will give you something to watch for when Congress starts drafting tax legislation later this year.