Tax Cuts and Jobs Act Changes Considerations in Section 1031 Exchanges
In a “Sizing Up in Violins and Investment Real Estate,” another post in the Orchestrating Real Estate series, I discussed how buying increasingly larger (and more expensive) violins compares to real estate investments. I discussed how starting with a 1/32 size, I had purchased a series of violins and then “traded up” to the next size through a 7/8 size violin. Each time, the primary purchase was a violin, but we also had to purchase a similarly-sized bow, case, and accessories in order to play the larger violin.
A real estate investor might start small, with a single duplex and eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings. In those instances, although the primary purchase was real estate, each purchase would come with a certain amount of personal property in the form of appliances, furnishings, supplies, and other equipment necessary to operate the real estate.
Comparing a real estate transaction to a violin purchase, purchasing the violin would be akin to purchasing the real property, and purchasing the bow and case would be more like the personal property that is purchased with the real estate investment.
My previous blog discussed how there are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.
Since 1921, one thing that has helped real estate investors accomplish growth while deferring taxes is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property. Over the years, Section 1031 has evolved, but generally, those changes have provided clarity or expanded the opportunities to defer taxes upon a sale and reinvestment.
The Tax Cuts and Jobs Act signed into law in December (2017 Tax Act) introduces new rules on 1031 like-kind exchanges by limiting the types of assets eligible for Section 1031 exchange. As a result of these changes, effective January 1, 2018, only real estate exchanges will be eligible for tax deferral. Using the violin “trade up” comparison, under the 2017 Tax Act, the violin could be traded for a larger one, but it would not be possible to “trade up” the bow or case.
Most real estate sales include the sale of at least some personal property: from refrigerators in an apartment complex to common area furnishings in an office building or maintenance equipment in a shopping center. Most of that personal property can be depreciated over just a few years or sometimes, expensed entirely under what is known as a Section 179 Deduction[1] which allows a limited amount of capital expenditures to be deducted entirely in the year in which they are made. Therefore, by the time the personal property is sold with the real estate, it likely has a zero basis. As a result, under the 2017 tax law, any amount of the sale price allocated to the personal property is very likely to be taxed either as capital gains or recaptured depreciation.
On the bright side, for many real estate asset classes, either there isn’t much personal property or the personal property doesn’t have much value in its used condition. For instance, even if there are 150 refrigerators in an apartment complex, if each of them is six or seven years old, the sale price isn’t going to be very high, so the resulting taxes won’t be material. However, there are situations where a real estate sale might include more valuable trade fixtures, equipment or machinery, for which a reasonable sale price allocation would result in significant taxes.
Where the potential tax liability for a sale involving both real estate and personal property is significant, careful planning can help to reduce the tax burden of these tax law changes. Strategies to explore include the following:
Consider leasing personal property. Payments made for a true lease (one that is not a disguised sale or installment purchase) can be deducted when made, providing a similar tax liability to depreciation (or a Section 179 deduction). Of course, with a lease, the lessee would not acquire any ownership in the personal property. If the lessee plans to sell the real estate to which the personal property relates and dispose of the lease obligation at the same time, the lease would need to be assumable by the buyer of the real estate or cancellable.
Offset Capital Gains Against Capital Losses. If the taxpayer has capital losses, then many capital gains can be offset against those losses so that no tax is paid. Because real estate assets may be held inside of a separate legal entity, the capital gains and capital losses must be allocable to the same ultimate taxpayer for this strategy to be effective.
Assign Property Values to the Personal Property Upon Sale. There is a natural tension between buyers and sellers when there is a sale of mixed real estate and personal property. Buyers tend to want to purchase price to be as heavily allocated to personal property as possible, both because they can depreciate personal property more quickly and because in some states, a high allocation to real property may result in an increase in real estate taxes or a high transfer tax bill.
Sellers sometimes agree to the buyers’ values in order to move forward with the deal. However, the reality is that many times, used personal property has little to no value in the marketplace – if you look on craigslist for instance, a used refrigerator or other appliance in good condition may sell for no more than 15-20% of the new value, and many times, the personal property sold with investment real estate has been heavily used. Proper valuations of the personal property can result in a smaller portion of the purchase price being allocated to personal property subject to capital gains taxes.
On a related note, the 2017 Tax Law may have adverse consequences for professional violinists Suppose a professional violinist starts with a nice, $10,000 modern Italian violin, which has appreciated to $40,000 over a period of many years while the violinist saved up to “trade up” to a $150,000 Vuillaume[2] violin. Under the 2017 Tax Law, this violinist is out of luck; since a violin is personal property, under 2017 Tax Law that violinist now may have to write a check to the IRS for the gain on the sale of the $40,000 Italian instrument acquired for $10,000 many years before.
© 2017 by Elizabeth A. Whitman
[1] The Tax Cut and Jobs Act of 2017 also modified the Section 179 deduction limitation so that many taxpayers will be able to expense up to $1 mil. per year in capital purchases instead of depreciating those items over time.
[2] Music Geek Fact: Jean-Phillipe Vuillaume was a 19th century French violin maker. He started his career in the shop of Francis Chanot, who had a reputation for forging violins. Before long, Vuillaume was copying violinists made by Stradivari and Guarneri del Gesu, two 18th century Italian master violin makers, whose instruments were already quite valuable. Vuillaume’s skill was so great that some of his instruments reportedly were mistaken for the originals. Vuillaume turned away from forgery and instead produced violins he acknowledged as copies (the difference between forged and copied violins being only whether the lack of authenticity is disclosed). Ironically, after Vuillaume won violin competitions in his own right, violins bearing his name became some of the most commonly forged (or shall we say “copied”) in the late 19th century. Today, a Vuillaume might sell for more than $250,000, with his copies of the famous “Messiah” Stradivari violin being among the most desirable.
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