Tax sheltering tool will gain popularity in new year
There are a few things in life that make me uncomfortable. The grocery store, for example, totally overwhelms me. The feeling of a new pair of jeans is absolutely unbearable. I think flu shots are shady. And don't get me started on the cellphone salesmen at the mall. But what makes me really queasy is giving advice on things out of my realm of daily expertise. I am a huge proponent of understanding your professional strengths and limitations and deferring to others when appropriate.
With that in mind, I decided to correspond recently with my friend Jason Rayne, a tax accountant at Purdy, Powers & Co., about the dreaded fiscal cliff. I am interested in what impact changes to the tax code will likely have on commercial real estate investors. In particular, we discussed a common tax sheltering tool investors use to defer paying capital gains, the 1031 Tax Deferred Exchange.
The 1031 Exchange, also known as a "like-kind exchange," is when an investor sells a real estate asset and uses all of the equity to acquire a replacement investment property of equal or greater value, deferring the capital gains tax that would typically be paid, and leveraging all the equity into the replacement property. It is a great tool to build wealth over time and save on taxes today.
But, as Jason points out, "the like-kind exchange merely defers potential gain until a later transfer of the property. This allows for tax savings today, but it does not protect that taxpayer from potential future gain if the property held is later sold in a transaction that does not qualify for like-kind tax treatment." In other words, Uncle Sam is going to get paid eventually.
The fiscal cliff that has been getting so much attention includes a number of major fiscal events. One is the expiration of the Bush tax cuts' 15% long-term capital gain tax rate. I asked Jason what the rate will increase to and how it will impact every taxpayer, not just high-income investors.
He explained, "For the last 10 years, lower income taxpayers [in the 10% and 15% brackets] have not had to pay federal income tax on long-term capital gains. Individuals in higher tax brackets have enjoyed 15% rates on long-term capital gains. In 2013, the long-term capital gain rates are set to increase to 10% for lower-income taxpayers and to 20% for those individuals with incomes above the 15% marginal rate."
Beyond the long-term gains impact, Jason further explains that, "the sunsetting of the tax cuts will also mean higher marginal income tax rates on ordinary income. It is also important to note that beginning in 2013, some higher income taxpayers may be subject to an additional Medicare surtax on earnings or investment income."
Protecting gains
Over the course of 2012, I found it interesting to track the motivation of sellers. For obvious reasons, we saw a lot more deals that required closing in this fiscal year. In some cases, sellers accepted lower prices in exchange for assurances of a quick closing. But, as the year comes to a close, investors need to come to terms with the new rates as explained above. Because that's a tough pill for many to swallow, I fully expect the 1031 Exchange to become a popular tax planning tool in 2013 and beyond.
I asked Jason to outline a few common misconceptions. One of the most common is that the relinquished property must be exactly the same type as the replacement property. This is not the case. "For example," he said, "when exchanging real property, as long as the productive business use or investment requirement is met, a taxpayer could qualify by exchanging farm land for an apartment building, or an apartment building for an industrial warehouse."
Also, the transactions do not have to occur simultaneously. "Taxpayers must use a qualified intermediary to facilitate the transaction, but as long as the replacement property is identified within 45 days of closing on the relinquished property, and the purchase of replacement property is closed on within 180 days of the sale of the relinquished property, the transaction should qualify for like-kind exchange," he said. But he warns 1031 Exchanges are complex transactions and one should consult with a tax professional when considering one.
It is clear that changes to the tax code are imminent. So it's wise to fully understand how these rate changes will impact every taxpayer, as well as real estate investor. If the dialog gets a little too complicated or uncomfortable, I suggest you talk to a trusted tax attorney or accountant. I did and would like to express my thanks to Jason. You can reach him at 775-3496 and JRayne@cpaforme.com.
Justin Lamontagne, broker at NAI The Dunham Group in Portland, can be reached at justin@dunham-group.com.
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