For years, the federal tax rate on long-term capital gains has been capped at 15%.
This year, the top rate for high-income taxpayers has been set at 20% while the 3.8% Medicare surtax on net investment income has taken effect. There are also renewed phase-outs of personal exemptions and some itemized deductions. “Altogether, some clients could have effective tax rates around 25% on their long-term gains,” says Dean Barber, head of a wealth management firm in Lenexa, Kan.
This steep jump in tax rates could have an impact on like-kind exchanges of investment real estate. “In recent years,” Barber says, “people might have looked at the 15% rate and decided an exchange wasn’t worth the bother. The higher rates may cause property owners to reconsider.”
As Barber puts it, there are many ways to “stub your toe” in a so-called 1031 exchange, which refers to the relevant section of the tax code. Although straight swaps are permitted, deferred exchanges are much more common. In these deals, a client who owns investment real estate might sell the property, park the money with an unrelated intermediary, and then have this third-party use the proceeds to buy replacement property for the client. Certain guidelines affect identification of possible replacements, acquisition of the new property, cash proceeds, and debt reduction.
If all the paperwork is handled properly, the client won’t owe tax on the property sale. For long-held properties, which have been depreciated and thus have a low basis, the taxable gain on a sale can be steep. Deferring and possibly avoiding the tax payment can justify the effort.
“There are two reasons for doing a 1031 exchange,” says Barber. “One is to increase cash flow, and the other is to spend less time with the real estate. A client of mine owns some rental property, which yields around 7.5% now. He’d like to cut back on the time he spends there, so we looked at selling the real estate, paying the tax, and reinvesting in securities. After he paid the tax on a sale, he would have to get 10% from the securities to maintain his income, which isn’t practical now.”
With a 1031 exchange, such a client would avoid the tax bill so all the sales proceeds could go into the replacement property. “We’ve had clients use 1031 exchanges to acquire properties leased to a corporate tenant like CVS or Walgreens,” says Barber. “Buyers of such properties might not get as good a deal on the purchase as a REIT might get, but they still can get cash flow along with moderate management responsibility.” This type of replacement property, Barber notes, could work well for a client who is relocating in retirement, is experienced with investment property, and would like something productive to do in the new area.
In some cases, the replacement property (or a subsequent replacement) is held until the owner dies. “I have seen people,” says Barber, “who are trying to avoid taxes and pass the money to the next generation. Assuming current tax law is still in effect, the heirs will get a step-up in basis. In that scenario a 1031 exchange would work well.” Property held at death would pass to heirs with its current market value as the basis, so all the income tax avoided during the owner’s lifetime would never be collected.