Eventually, of course, the tax man will not be denied: at some point, the gains will be recognized. But this tax code section allows you to put off the day of reckoning for a while.
But now word comes that many real estate moguls and tax advisors are backing away from these kinds of transactions. Why? Well, there’s a simple reason. Right now, the capital gains tax rate is 15% on long-term capital gains. There are some who fear that, depending on the outcome of the upcoming election, the capital gains rate could go to 20% or even 25%, especially if a Democrat becomes president and follows through on his or her positions.
So the question becomes: do I take the 15% hit now, or do I wait five years and take a potential 25% hit?
Let’s look at some numbers. If you have a $100,000 long-term capital gain, you could roll it over into a new piece of property or pay the tax now. If you pay now, you pay $15,000 in taxes. What happens if you know you will hold the piece of property for five years?
Assuming you don’t make or lose any value, you would pay $25,000 dollars five years from now. That’s basically paying $2,000 per year for deferring the tax man. Is it worth it? Well, if invested, that $15,000 probably wouldn’t make $2,000 a year in returns.
If the sale were made after ten years, the calculations would be different, so this is clearly a case-by-case scenario. And, of course, other calculations come into play here. What happens if your new property value plunges? You would pay less tax. Also, it’s possible that the capital gains tax rate won’t be changed for some reason (Congressional deadlock, for example). For that matter, you may just want to hold on to that investment property for the long term.
This presents an interesting problem for qualified intermediaries, the middlemen through which a Section 1031 exchange happens.
Under the terms of a Section 1031 exchange, you have to actually exchange the properties in question — i.e., trade one property for another. Since it is rare that you and the other party want to actually exchange properties, a third party enters the picture. The third party gets the deed, and then sells it to the buyer of property A. The proceeds are then used to buy property B, and then the seller gets the deed to property B back.
Section 1031 is complex and includes strict guidelines. Thus, for most Section 1031 like-kind exchanges, professional help (real estate lawyers or tax lawyers) is highly recommended. If Section 1031 deals start dropping in frequency, qualified intermediaries will most likely start feeling the heat. As most qualified intermediaries are dedicated companies or agents, this is not good news for them, though the potential downturn is probably not long-term. Once the new tax rates (if any) on capital gains taxes kick in, Section 1031 exchanges will probably resume at full strength. This is subject, of course, to the regular factors that influence these changes.
On the flip side, if there are new tax rates, there will be a sudden influx of work for investment advisors and tax specialists from those who are seeking relief from new long-term rates.
So for long-term employment prospects, a sudden change in the tax laws with the start of a new administration will likely boost investment advisors and those who manage tax-oriented accounts.
