Uncertain Times: Planning Your Real Estate Tax Alternatives

These are crazy, uncertain times. If you’re selling a property, do you know what to do? Do you sell it and pay the tax, or do you roll the dice on a 1031 exchange? Is this a once-in-a-lifetime opportunity to take your gain at a low tax rate (as low as we may see for awhile)? Or is paying the tax simply a waste of money? What if I told you there is a way to take the guesswork out of your decision?

As I write this, McCain and Obama are neck and neck in the race to see who will be the next President of the United States. The one who wins will probably be the one who is able to sway the greatest number of undecided voters to his side. Typically the undecided don’t make up their minds until the last minute, which means that this race looks like it could go down to the wire.

Campaign rhetoric doesn’t mean much, but it gives us an idea of which way the candidates are leaning: McCain says he’ll leave capital gains taxes where they are (at 15%) and Obama says he’ll raise them to 25% or 28%. If you assume that Obama wins, now might be a great time to pay a low tax rather than do a 1031 exchange. Also, since you won’t be doing an exchange, you can take your time finding another property to invest in. And because you won’t be rolling your basis over from the Old Property, you’ll get a step-up in basis on the New Property which will give you higher annual depreciation deductions.

Obama vs. McCain:
...This is a hard call, and you have to make a decision today. Which option is the lesser evil...

But if McCain wins, the better option would be to do a 1031 exchange and roll the gain over to the new property, because paying the tax right now would be a waste of money. The part that most people in the “pay the tax now” camp miss is that the tax isn’t simply 15%. The capital gains PORTION is 15%, but then you also have depreciation recapture (typically 25%) and Colorado state tax (typically around 5%). If your gain was $100,000 (half of which was depreciation recapture), your total tax bill, federal and state, would be about $32,500; almost one-third of the gain, and more than twice the 15% rate you thought you were going to pay.

Another thing most people miss is that, yes, you do get a step-up in basis on the New Property, but it could take you as much as 39 years to recover the tax you pay today through larger depreciation deductions over that time span. How old are you? Will you ever see that money again?

This is a hard call, and you have to make a decision today. Which option is the lesser evil – pay the tax today and then find you didn’t need to, or do an exchange today and find you’ve missed a great opportunity to pay taxes at an all-time low rate? What if I told you that there was a way to have your cake and eat it too? What if you could sell your property today, and then decide after the election whether you want to take advantage of the low tax rate, or keep your cash and maximize your investment?

You can have your cake and eat it too, and here’s how: First, sell your property today and do a 1031 exchange. You’ll have 45 days to identify what you might buy to complete your exchange. Be serious about your list of properties because you might very well end up buying one of them.

Secondly, you will have 180 days from the closing to complete the purchase of your replacement property. Since the 180 days deadline will fall long after the election, you won’t need to close the purchase of the New Property before the election. Make sure that any contract you sign provides for a closing date that falls after the election.

On November 5th we will know who the next President is (barring hanging chads, dimpled chads, pregnant chads, etc. etc.) and at that point you can determine your next step. If McCain wins, you simply complete your exchange by closing on the purchase of the New Property. If Obama wins and you want to pay the tax, simply collapse the exchange causing the sale of your Old Property to be taxable in 2008 under what may be lower tax rates. You have at least until November 5th to decide what you will do.

How do you collapse or fail your exchange? The simplest way is to either not buy any replacement property, or to buy one that isn’t on your 45-day list. If you want to acquire the property you identified, but you don’t want to complete your exchange, you have to step more carefully. Contrary to what many people believe, you can’t simply say “I no longer choose to treat this transaction as an exchange.” The law does not allow you to change your mind and pay the tax instead (although it’s hard to imagine the IRS refusing to accept your check).

Another easy way is to acquire the replacement property and yet fail the exchange would be to acquire the replacement property using a different taxpayer with a different tax identification number. For example, if you held title to the Old Property as “Fred Jones,” then Fred Jones is the party doing the exchange. If Obama wins and you decide that it would be prudent to pay the tax, yet you still want to acquire the property you identified, simply acquire the New Property as a different taxpayer. For example, you could acquire the property as “Jones Investment Corporation” which would be a different taxpayer – this would cause your exchange to fail, yet allow you to acquire the property you want.

I don’t have enough print space to go into all of the possible options you have to accomplish your objective. But I think you get the idea: close the sale of your Old Property now, do a 1031 exchange, defer the COMPLETION of the exchange until after November 5th, and proceed at that point to obtain your objective, when you know what (who?) the key variable is.