Three Things Impacting a Decline in 1031 Exchange Activity

A review of 1031 exchange activity reflects $73.6 billion dollars deferred in 2005 decreasing to $2.5 billion estimated by the Joint Committee on Taxation in 2011. There is an increase in exchange activity for 2012 with a projected $3.2 billion amount of tax deferrals. As a Qualified Intermediary who accommodates exchanges, it is my opinion that there are three fundamental reasons for the decline.

If doesn’t take someone staying at a Holiday Inn to recognize that home values have plummeted from their highs in 2005. The total available disposable income used by many investors to buy and sell investment property has evaporated. This lowered income, combined with the stock market decline, is impacting every area of our economy.  Millions of jobs supporting the housing industry from the construction and timberland industries to related service industries have either phased into another line of work or reduced their operating expenses to near a flat line to maintain.

The real estate market was that once expected to revive in 2011 will instead require years to ultimately absorb the abundance of underwater properties facing short sales and foreclosures. These conditions are also opportunities for those sections of the country supported by strong job growth, as they will experience demand for undervalued homes. Investors recognizing the value are acquiring properties.

Bonus depreciation allows a taxpayer to write off investments in capital equipment at an accelerated rate, in addition to the maximum allowable under Section 179 expensing limits. Bonus depreciation was enacted to help an ailing economy by providing taxpayers an incentive to acquire and depreciate the cost of qualified property during the first year the property was placed in service. Equipment acquired and placed into service from December 31, 2007 through September 8, 2010 qualified for a fifty percent bonus depreciation. From September 8, 2010 through December 31, 2011, 100 percent depreciation for qualified investments applies. A fifty percent bonus depreciation will be available for calendar year 2012, though there is a possibility the rate may be changed to 100 percent.

The impact of bonus depreciation on 1031 exchanges is that the 1031 tax deferral benefit is diminished if not necessary. Depending on the transaction, the recognized gain or tax due on the sale of qualified property is offset by the depreciation benefit. Writing off 100 percent of the purchase price in the first year is an attractive outcome for the taxpayer. However, when the asset is sold, a recaptured depreciation tax equivalent to 25 percent of the depreciation taken will be due, unless the property is replaced in a like-kind exchange.

In 2003, the long-term capital gains for assets held for more than one year was reduced to the current rates of 15 percent and 5 percent for individuals in the lower two federal income brackets. Unless Congress acts to maintain the status quo, the rates will increase to 20 percent and 10 percent. The Health Care Bill includes a 3.8 percent Medicare tax on investment income (interest, dividend, capital gains, annuities, rents) earned by those with income in excess of $200,000 (single) and $250,000 (joint). The applicable capital gain rate will be 23.8% effective January 1, 2013.

If you are considering a 1031 exchange, it may be in your interest to pay the tax, given the current historically low capital gains rates.

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