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Tax & Spend Is About to Hit Real Estate Investment Hard

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This is a great country, and most of us are fine with paying our fair share to keep it that way. We like our nice highways, and we enjoy the protection afforded by our police forces and the military. It takes money, and taxes are how these amenities are funded. However, it seems that for quite a few years now, and in both Republican and Democratic administrations, there are always multiple proposals being discussed to increase revenues. What is missing is pretty much any discussion of cutting costs, or reducing government waste and fiscal irresponsibility.

This year there are some alarming discussions in Congress directly targeting the 1031 Exchange used by real estate investors to postpone capital gains taxes on real estate transaction profits. If you sell a stock market investment for more than you paid, you're happy, and you're going to pay capital gains taxes, normally in the year the gain is realized. Real estate investments enjoy a special tax advantage provided by IRC Code 1031. There are a whole lot of rules and deadlines involved, but the highlights of the 1031 Like-Kind Exchange include:

• Real estate acquired for investment purposes normally qualifies.
• Like-kind is liberally applied, so selling a piece of land at a profit, you can use the 1031 Exchange to buy a rental home. The key is that they're both "real estate" used as an income-producing investment.
• When you do this within the rules, your profit from the sale is not subject to capital gains taxes at that time. They're deferred until later, whenever you liquidate your investment completely.
• This means that you can continue to roll your profits up into more valuable properties over time, never paying the capital gains taxes until you sell out of the assets. You're getting Uncle Sam to participate in the growth of your nest egg.
• If you die and leave your property portfolio to your heirs, they receive it at the "stepped-up" value. That's the value at the time of inheritance. This means that all of those capital gains just disappear, and they can sell the property if they want without liability for them. Yes, you can take it with you... kind of.

It can be easy for someone to think it's unfair for investors to avoid capital gains throughout a long life, as it may seem like they're not paying their fair share. However, what gets lost in the discussion a lot is the fact that this single tax provision has spurred residential and major commercial real estate sales and development since its inception.

IRC Section 1031 has created a huge buyer demand over the years for everything from rental homes to shopping centers and office buildings. It allows the investor, in fact requires it for maximum tax advantage, to roll most or all of the proceeds of the sale into the new purchase, and within a specified period of time. There's no way to quantify it, but I'm relatively certain that a major chunk of investor real estate purchases over the past few decades would not have happened if this advantage were not in place.

At the very least, new commercial real estate development would have been slowed significantly. You may not have that fancy new shopping mall nearby without the 1031 Exchange. Definitely there would be far fewer apartments out there today. With rental demand increasing, rents would be through the roof if a large number of those big apartment projects didn't exist.

Congress has no fewer than three different proposals being discussed right now, and all of them either completely do away with the 1031 Exchange or do enough damage to it that real estate investment activities will plummet in the future. The news is full of the waste and inefficiency of the Veterans Administration and other government agencies, including the U.S. Postal Service. Private business can't continue to exist if it's consistently unprofitable, but the government doesn't suffer from efficiency requirements.

I think that it will be extremely harmful to the already fragile economy if the 1031 Like-Kind Exchange is dismantled or severely limited. This isn't a time to be inflicting more blows to the economy and jobs. It's a time for more discussions of how to cut the cost of big government instead of how to fuel the spending fire.