Crystal Ball Gazing - 1031 Exchanges in 2013

Again, at this time of year, I'm writing my usual end-of-the-year prediction on where I see the 1031 exchange industry going in the coming year (which in this case is 2013).

As I write, there doesn't seem to be any common ground between the Democrats and the Republicans in Congress. But regardless of whether we go off the cliff or not, taxes are going up next year. Americans seem to favor raising rates on those taxpayers in the $250,000-and-up tax brackets. Republicans are resisting this, but I don't see them winning the argument, so I expect capital gains for the top bracket to rise from the current 15% level to 20%. In addition, taxpayers in the upper brackets will also be subject to an ObamaCare tax of 3.8%. In other words, if your taxable income next year exceeds $250,000 you can expect your capital gains tax to rise from 15% to 18.8% for sure, and probably 23.8% overall. Add to that a Colorado tax of almost 5% and you're looking at a tax on your gain, if you're a Colorado resident, of almost 29%. 

If you sell depreciable property, the portion of the gain that's equal to the sum of your accumulated depreciation deductions is currently taxed at 25%, rather than 15%. I don't see that part of the law changing – you'll still have to pay tax on the depreciation deductions you've taken on the property. And there's been no discussion at this point of increasing the "repayment tax" above 25%. 

To give you an example of how this works, if you sell a property this year at a gain of $100,000, and you've taken a total of $40,000 in depreciation, then $40,000 of the gain would be taxed at 25% (or a tax of $10,000), and the balance of $60,000 would be taxed at 15% (or at tax of $9,000), for a total tax of $19,000 or 19% of the gain. Adding a Colorado tax of $5,000 gets your tax total to $24,000 or 24% of the gain. That's under current law. 

Next year, assuming the gain kicks you into a tax bracket above $250,000, (and assuming that Obama gets his way), your tax on this gain might be as follows: first, your depreciation capture will remain unchanged at 25% of $40,000 or a tax of $10,000. Your capital gains tax of $60,000 will now be taxed at 23.8% (the new capital gains tax of 20% and the 3.8% ObamaCare tax) for a tax of $14,300, and the Colorado tax will remain unchanged at $5,000 for a grand total of $29,300 which is just shy of an overall tax rate of 30% of the gain. 

If you do a 1031 exchange, none of these taxes would apply, and your gain on the sale would be deferred into the new property. So what's the possibility of a change to Section 1031 itself, or its elimination altogether? Every President since, I think, Lyndon Johnson has looked at eliminating Section 1031. Clinton and Bush both looked at it twice, and Obama's already looked at it once before. The Congressional Budget Office has done a number of studies on the impact of doing away with Section 1031. All of them, so far have concluded that the government loses tax revenue if it eliminates Section 1031 because people would hold on to their property rather than sell it – creating less tax revenue overall. Another reason I don't expect Section 1031 to be messed with is that in the overall big picture, the tax revenue "lost" through Section 1031 is about the size of a zit on a fly on the elephant of the federal budget, and isn't worth Congress fighting the real estate lobby over. 

I wish that I had a crystal ball that told me exactly what Congress and the President were going to do about the fiscal cliff, but I've lived long enough to know that nothing they do will really surprise me in the end.