1031 Exchange may not be so sweet a deal down the road

by Steve Crossland, REALTOR in Austin TX on May 18, 2007 · 0 comments

I run into a lot of investors looking to take advantage of the 1031 Exchange. If you’re not sure what a 1031 Exchange is, there’s a good article about the 1031 Exchange on the Texas A&M Real Estate Center website. As the article states, “the key advantage of a 1031 exchange is that it allows an investor to dispose of a property without incurring a capital gain tax liability.” The capital gain tax liability isn’t avoided, but is delayed – to be paid in the future upon the eventual non-exchange sale of the final property.

As the logic goes, the current unpaid taxes can be applied to a larger down payment on a new property, thus allowing an investor to acquire a more expensive replacement property than would have been possible with the lesser after-tax proceeds that would be available without the 1031 exchange.

The question that comes up for me when considering the advantages of delaying the payment of a capital gain tax liability is “what tax rate will I be paying when I eventually do pay the tax?”.

I’m not an accountant, nor am I adept at complicated financial equations (my only ‘D’ in college was in Finance), but I do think the capital gains tax rate we currently enjoy of 15% is historically about as good as it gets, and it may not be this low for much longer. It’s only been this low twice (15% in 1916, 12.5% from 1922 to 1933 according to this chart).

If the political climate of the near future results in the Democrats retaining control of both the Congress and Senate, and a Democratic President is elected, I personally think it’s a foregone conclusion that a Capital Gain tax increase will soon follow. Presidential candidate John Edwards said so in an interview with Tim Russert recently on Meet the Press. He said he would consider raising capital gains taxes to help fund his spending plans.

In an April 17, 2007 Wall Street Journal Op-ed piece titled “$650 Billion Tax Hike”, Stephen Moore, wrote “Democratic tax experts also recommend eliminating the lower rate for capital gains and dividends for those subject to the AMT. This would raise the capital gains tax rate to about 31% from its present 15% rate.”

So if I want to dispose of one of my rental properties this year, should I go ahead and pay the 15% capital gains rate now, or take a chance that the deferred capital gain will be subject to a higher tax rate when I finally do pay it later on? I think the answer might be depend on the amount of the capital gain as well as other variables, such as one’s income tax bracket, that will vary from investor to investor.

My advice is simply to have a conversation with your accountant about this subject before blindly assuming that a 1031 Exchange is always a good deal.

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