Sizing Up in Violins and Investment Real Estate
If you have ever attended an elementary school instrumental music concert, you may need your parental pride to outweigh the general cacophony that is inflicted on your ears. Sometimes, however, you may find a group of violins that sound pretty good. Why is that?
Well, for technical reasons, string players can start younger[1]. As supply meets demand, violins can range from a 1/32 size up to full size. Therefore, a child can start playing the violin on a tiny instrument at a very young age and “size up” on violins as he/she grows.
There are two strategies for obtaining violins for a child: rent or own. If you rent, you just pay each month for your child’s entire career. If you choose to buy the violins, you will keep buying and disposing of increasingly more expensive violins. I looked at the math and decided to buy my son’s violins.
My son started at age three playing a 1/32 size violin, which with an eight-inch body looked more like a toy than a violin. At age five, when he moved to a 1/10 size, we also found a need to move up a step in quality (and therefore, price) with each size increase. A few months ago, my son traded in his ¾ size violin for a 7/8 size instrument, which is valued at 20 times the price we paid for that original 1/32 size violin nearly nine years before.
When we made the most recent violin purchase, I realized how our “investment” in violins is like real estate investment. A real estate investor might start small, with a single duplex. That duplex might be sold and the money reinvested in a four-plex, and the four-plex might in turn, be sold and the proceeds reinvested in a more expensive three-story office building. 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.
Unlike with violins purchased for my son, a real estate investor has to think about taxes with every “trade up.” 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. Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.
One thing that helps real estate investors accomplish growth in 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 within 180 days.
When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties, as would occur if my son were to literally trade in his small violin at the violin shop for a larger sized violin. For a direct swap, tax deferral makes a lot of sense. It can be difficult to determine the “sale prices.” Plus, unlike a sale and reinvestment, a sale doesn’t result in a cash payout from which taxes could be paid.
Therefore, over the years, Section 1031 exchanges have evolved so that they are more useful to real estate investors.
For instance, another option with violins, is to sell the smaller violin to another student and then use the money to buy the larger sized violin from the violin shop. Likewise, a real estate investor might choose to sell that duplex to Company A and use the proceeds to buy the four-plex from Company B.
For the past 30+ years, the tax law has allowed real estate investors to use what is known as a “qualified intermediary” to do the real estate equivalent by for instance, exchanging an apartment building sold to Company A with an office building purchased from Company B. Without going into the detailed rules for this 1031 exchange, this would roughly equivalent to selling the smaller violin to another student, then putting the proceeds of the sale in a special savings account that could only be used to buy a new violin, once the desired instrument was located.
1031 Exchanges, however, are seen by some as a tax loophole for real estate investors. The Republican tax proposal “A Better Way” would significantly change the tax laws, including those on investment real estate. The proposal includes a full and immediate expensing of investment in place of depreciation.
Although this proposal might simplify the tax laws, it is likely to complicate the tax situation for many real estate investors. 1031 exchanges are not specifically mentioned in “A Better Way,” but some believe that 1031 exchanges might be abolished along with depreciation. If that were to happen, real estate investors likely would be taxed on their proceeds upon sale of their real estate. This would limit available cash for real estate investors’ to “trade up” and potentially could slow down the recovery of the real estate market.
Therefore, although it seems likely that there will always be a crop of younger violinists in need fractional-sized violins as you “trade up” to larger instruments, tax laws may not always make it as easy to “trade up” your real estate investment.
© 2017 by Elizabeth A. Whitman
[1] Geek fact: A partial explanation is that strings of different length can reach the same pitch by changing the tension, while wind instruments require a certain length of the air column to produce a pitch. So if you want to start your five-year-old on a bassoon, you may need to stretch him a bit first. Also, wind instruments require a developed mouth and certain number of permanent teeth, which are not required for string instruments.
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