Sylvia: For a change, I’m using this blog to sound off myself.
Savvy real estate investors with ample assets can avoid ever paying taxes on gains in the value of the commercial property they own. They can even use paper losses on such holdings to offset their income from salaries, profits from trading stocks, whatever. The Republicans say they’re setting out to reform the tax code. Here’s one aspect of it that badly needs reforming.
Professional real estate wheeler-dealers-–almost certainly including Donald Trump–-routinely use this dodge to avoid paying property taxes indefinitely. No wonder he doesn’t want lesser mortals to see his tax returns. Nonetheless, under the federal tax code this is all perfectly legal. It involves using two sets of regulations in sequence.
The first is depreciation, the government’s assumption that the value of a physical asset drops over time. The second is an obscure procedure called a 1031 exchange (referred to as a “ten thirty-one exchange.”) More about that later.
The IRS sets arbitrary rates for depreciation on different classes of assets. For instance, you’re generally required to “depreciate” rental property over 27.5 years, at 3.636% per year. You or your accountant are expected to claim this paper depreciation on your property as a loss-–even though in fact it’s probably been going up in value while yielding income in the form of rent.
Unfortunately for the middle-class wage earner or small business person trying to get ahead who’s invested in a rental house with mortgage to match, selling that investment can cost big in taxes. Suppose you bought a house for $100,000 and after ten years it’s gone up in value 50% but you’re still paying off that pesky mortgage while sweating out the headaches of being a landlord. Now you want or need that money for something else: to pay off medical bills, to put kids through college or graduate school, or just to take early retirement and travel around the world. You figure that if you sell your house for $150,000, you can lock in a tidy profit. Good luck with that. Internal Revenue has other ideas.
Over ten years, they’ve generously granted you $36,360 in depreciation on your $100,000 house — but obviously its value hasn’t gone down at all. Suddenly, if you sell it, they take all that money back. That loss for tax purposes becomes a gain and you have to pay taxes on it along with the $50,000 increase in the value of the property. Now you’re subject to taxes on long-term gains of $50,000 + 36,360 = $86,360. Painful – but probably fair. Except that, from the point of view of bigger time operators, paying such taxes is just for suckers. A convenient tax dodge leaves them free and clear.
The 1031 Exchange
Suppose instead of selling your investment property outright, you trade it for a similar property of equal or greater value. If you follow a set of tricky procedures stipulated by the IRS, you can avoid paying taxes on your profits indefinitely. You have just 45 days to identify your replacement property and must close on it within 180 days after your original property settles. In practice, it’s customary to first locate a replacement property, place a deposit on it to hold it, and then set about selling the property you already own. If you google “1031 Exchange” you’ll discover that a small industry of real estate brokers and lawyers is eager to guide any willing investor through these hoops for a fee. Then you can use IRS-mandated depreciation on your new property to reduce taxes on any other income you may have.
Unfortunately, most of us ordinary working stiffs are unlikely ever to cash in on the benefits of these arcane regulations. We lack the ample capital, credit, flexible schedule and expertise to make such a tax dodge pay off for us.
Tax Rates of the Rich and Famous
Until Donald Trump came onto the political scene, candidates for president routinely made their tax returns public. In 2012, news that Mitt Romney had paid federal taxes of just 14.1% on his income, received mostly from investments, aroused indignation. In recent years, much sound and fury but little action has been directed at IRS regulations that grant special treatment to professional hedge fund managers, not an especially needy group. Top earners often collect over a billion dollars a year! Yet since most of their compensation is classed as capital gains rather than normal income, that portion is taxed at just 15%.
Meanwhile, by using IRS regulations on depreciation and the 1031 exchange, real estate moguls can escape taxes altogether. Take it from two experts, Donald Trump and Robert Kiyosaki, a self-proclaimed real estate millionaire, who in 2013 jointly published Why We Want You to Be Rich.
In it Kiyosaki writes, “There are many ways a real estate investor can avoid paying taxes legally—ever. One way is known as the 1031 tax-deferred exchange. Last year [my wife] and I sold a small apartment house and made over a million dollars in capital gains. By following the rules of the 1031 exchange, we were able to reinvest that money without having to pay taxes. This tax-deferred treatment is not available for people who invest in stocks, bonds, and mutual funds. You’d be surprised how fast you can get rich if you reduce or eliminate taxes.”
Now Republicans claim they want to reform the federal tax code by cutting taxes for the middle class. Good on them – provided they do so without slashing public services or causing a spike in the national debt. Any honest and honorable rewriting of our nation’s tax laws will do away with or drastically reconfigure the 1031 exchange.