The Perfect Storm: Surge in 1031 Exchange activity in 2014

In the real estate market, the convergence of much higher tax rates, a very strong commercial market, and a recovering residential market have resulted in a surge in 1031 exchange activity this year.. This article explores each of the three factors creating this "perfect storm." Factor #1: Higher Tax Rates: 1. Depreciation Recapture: Depreciation recapture is taxed at 25% on all depreciation recapture. 2. 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 investors in a lower tax bracket. 3. 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. 4. State Taxes: Investors must also pay the applicable state tax (which can be as high as 13.3%). 5. Local Taxes: Residents and property owners in New York City and the boroughs are subject to a local capital gain tax of 3.8%. Chart #1 demonstrates the various Federal Capital Gain rates applicable to capital gains depending on an investor's adjusted gross income. Factor #2: Robust Commercial Markets Commercial real estate (CRE) prices nationwide are about 3% above the previous market peak in 2006. International investors see the U.S. as a safe haven, and their demand further fuels the CRE activity. Commercial investors have strong borrowing and buying capacity, allowing them to capitalize on favorable CRE opportunities. 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. 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. The "perfect storm" resulting from the convergence of these three factors has led to an increase in 1031 exchange activity. Pamela Michaels is an attorney and vice president of Asset Preservation, Inc., Manhattan, NY. As a "Qualified Intermediary" as defined in the Section 1031 regulations, Asset Preservation, Inc. is not able to provide legal or tax advice. Accordingly, you should review the details of your specific transaction with your own legal or tax advisor. Copyright, 2014