Tuesday, January 17, 2017

How the Tax System Favors the Wealthy - 1031 Exchanges

If you are wealthy or even moderately wealthy, can you avoid paying taxes legally?   Yes, yes you can.

More viewer mail:

Hi Robert,

I read your post on converting ordinary income to capital gains. I have a question. Can you use a 1031 exchange to eliminate capital taxes on the sale? For example, a $100k property depreciated at 10% yearly with breakeven rents. According to your post, if sold for $200k minus Adjusted Basis $0, I would owe capital gains on the full price ($200k). Would a 1031 exchange wipe out the capital gain tax?

Short answer:  It would delay, not wipe out, except in two circumstances.

For example:

I bought a duplex for $95,000 in 1995.  I rented this out for ten years (approx) taking $9500 in depreciation deductions annually on my taxes - effectively lowering my income by that amount.  At the time, I was making well over $100,000 a year, so this knocked down my taxes quite a bit (I also had two other rental properties), as I was in the 35%+ bracket.  In effect, this was converting my ordinary income into capital gains and then deferring the tax until years later - if ever.

I then sold the property for $250,000 which would have been 100% taxable gains as the property was "fully depreciated".  Instead, I did a Starker-type deferred exchange or a 1031 as is now called, and bought two condos in Florida.  I rented these out but could not depreciate them, as the purchase price was equal to the un-taxed gains I used to purchase them.   If I had bought a $350,000 condo and kicked in my own cash (or got a mortgage) I could have depreciated another $100,000 - plus deducted the mortgage interest of course!

Now, if I sold those and took cash, I would have to declare this as a capital gain and paid taxes at 15% or so (consult a tax adviser for details).   So instead of paying ordinary income tax at 35% for ten years on $95,000 of income, I am paying 15% tax on that money more than a decade later.   I get a 20% drop in the tax rate plus delay the taxes.

"A tax delayed is a tax denied" as my tax law professor always said.  He showed us on the blackboard, using higher maths, how in effect, the delay means you have that capital to invest, and using the seven-year doubling rule (money doubles every seven years, if invested) you end up wiping out that 15% tax with your gains from that money in the interim.   Opportunity cost arguments work here, as this is an investment scenario, not a spending one.

But wait, there's more.

What I did with one of the condos, as I recall, was declare it as my primary residence, lived there for three years, and then sold it tax-free.  Yes, this is actually legal.  Or at least it was - in 2009 they changed the law and adjust the gains based on the number of years it was rented.  So this "loophole" has been partially closed.

I had to pay all the capital gains taxes on the other one, though.   But considering I put nothing down on the purchase of the original duplex and then folded that into the condos and then sold those for twice what I paid for them, I am sure you feel sorry for me that I had to pay capital gains on $250,000 of income when I realized $500,000 gain from the overall sale.

There is another way to avoid paying the capital gains taxes entirely - DIE.  If you die, the property transfers to your heirs tax-free (to them) and they get a stepped-up basis to the retail value, so if they sell it right away, they pay no capital gains tax.  The rich get richer, and heirs inherit tax-free.

So you can avoid the tax on the gains two ways - convert to primary residence (which used to be a freebie, but now is not as great a deal)  or DIE, the latter being less advantageous.

But even if you don't avoid the capital gains tax entirely, if you delay it, you come out ahead, and by reducing a corresponding amount of your ordinary income and "converting" it to a capital gains, you come out ahead.

Consult your tax adviser for details - there are a lot of forms and conditions with a 1031 exchange and deadlines as well.   And as you can see, the rules are changing all the time.  So it pays to pay someone to assist you with this - as I did.

Weird system, no?   Sort of favors people with money.