By Scott R. Saunders
In the movie The Perfect Storm, the convergence of two large storm systems led to unusual weather conditions that ultimately resulted in the demise of the ship and its crew. In the real estate market, the convergence of much higher tax rates, a very strong commercial market, and a recovering residential market has resulted in a surge in 1031 exchange activity this year.
Although real estate investors are experiencing solid gains, they are faced with a headwind of high taxation which threatens to significantly reduce investment returns. Consequently, investors are actively seeking out ways to reduce their tax liability. Once again, Section 1031 of the Internal Revenue Code has emerged as a valuable tool for boosting net investment returns by reducing tax liability, and for preserving capital for reinvestment into better performing “like‐kind” replacement properties. This article explores each of the three factors creating this “perfect storm.”
FACTOR #1: HIGHER TAX RATES
Tax rates, and their impact on an investor’s net investment return, can drive investment decisions. Economist Art Laffer posited that, as tax rates increase, actual tax revenues can decrease as a result of efforts by investors to mitigate tax consequences. In essence, as tax rates increase, an investor’s motivation to defer or postpone immediate taxation also increases. This is reflected currently in an increase in 1031 exchange activity.
Many investors are surprised to find out that today they may face four different taxes and, when combined together, the aggregate impact can result in a large tax bill owed to the government:
A. Depreciation Recapture: Depreciation recapture is taxed at 25% on all depreciation recapture.
B. Federal Capital Gain Taxes: Federal capital gain taxes are assessed on the remaining economic gain depending on an investor’s taxable income. Investors in the highest bracket pay at a 20% rate and a 15% capital gain tax rate applies to other investors.
C. Net Investment Income Tax: Pursuant to IRC Section 1411, an additional 3.8% surtax applies to
taxpayers with “net investment income” who exceed certain threshold income amounts.
D. State Taxes: Investors must also pay the applicable state tax (which can be as high as 13.3%).
FACTOR #2: ROBUST COMMERCIAL MARKETS
Currently, commercial real estate (CRE) prices nationwide are about 3% above the previous market peak in 2006. Domestic commercial investors, institutions, and real estate investment trusts (REITS) continue to exhibit a strong appetite for quality commercial properties. International investors see the U.S. as a safe haven, and their demand further fuels CRE activity. Commercial investors have strong borrowing and buying capacity, allowing them to capitalize on favorable CRE opportunities. The demand for quality CRE assets is so strong that CRE activity is now beginning to expand to secondary and non‐core markets. All of this CRE activity is contributing to the surge in 1031 exchange activity as CRE investors utilize 1031 to minimize the tax impacts of their transactions.
Sales of office, retail, multifamily, hospitality and land were approximately $370 billion last year, 18% higher than the year before, and the strongest year since 2007 and this momentum is continuing in 2014. Vacancy rates have decreased and net absorption has been strong in the office, industrial and retail market. Last year and continuing into this year, investors continue to be very active in the hotel property sector which was up 40%, industrial increased by 23%, office up by 18% , multifamily rose 14%, and retail rose 10%. In addition, REITs appear to be very active this year with a projected pace of acquisition and expenditures running about 60% higher than the pace of dispositions. More evidence of the strong commercial activity can be seen by the year‐to‐date rent growth in the U.S. apartment market is the best since the economy started to recover from the Great Recession according to Axiometrics Inc.
FACTOR #3: RESIDENTIAL HOME PRICE RECOVERY
According to the Case‐Schiller Index of 20 major cities, home prices nationwide have recovered by about 20% from the market trough. Among the nation’s 35 largest metro markets, all but St. Louis and Kansas City have experienced year‐over‐year home price increases as of April, 2014. Those with the most notable annual increases include Riverside (22%), Las Vegas (22%), Sacramento (16%), and Orlando (16%). Forecasts show about one‐third of the nation experiencing home appreciation higher than the national average over the next 12 months. Rents on single family rentals have also increased, rising by 2.3% on a year-over-year basis. Also, the lack of new home construction during the Great Recession has led to a shortage of new single family homes, further pushing up home prices.
The recovery of residential home prices is another factor causing an increase in 1031 exchange activity. However, since home buyers are generally more sensitive to increases in the interest rate than CRE investors, rising interest rates in the future could have a negative impact on demand for single family home purchases.
The “perfect storm” resulting from the convergence of these three factors has led to an increase in 1031 exchange activity as investors turn to this powerful tax strategy to preserve investment equity and improve returns. This increase in activity has led to a significant increase in demand for secure, knowledgeable, and service‐oriented qualified intermediary (QI) services. As always, investors should discuss their tax situation with their tax advisor to assess the potential value of using Section 1031.gu
Learn more about 1031 Exchange, join us at the August Monthly Meeting when Greg Schowe from API Exchange will be joining us to share his expertise on the subject. Click Here for Details and to Register.