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A Hitchhiker’s Guide to the Galaxy… of Tax Reform

Would you pick up a hitchhiker?

Hitchhiking essentially began with the advent of the automobile and was a popular source of travel for decades. Then, in the mid-seventies, the practice largely disappeared. Why? In part, it was because stories started to appear in news reports detailing a relatively few random acts of assault (and worse) to and by hitchhikers. The stories became urban legends. They were expanded to include non-participants, personalized, embellished, spread amongst friends, and finally, accepted as fact. The statistics never did bear out the popular conception.

Not so different than the hitchhiker stories, a proposal being considered by the House Committee on Ways and Means has been exaggerated and shared by some with the hope that it will be considered as fact (and the true motive of selling an investment properties in 2014?). To this end, there has been a flurry of emails and articles delivered to investors proclaiming the end of the 1031 exchange. Yet another round of emails have been delivered claiming depreciation time frames for commercial and residential real estate are to be lengthened, but repetition of a half-truth does not create a whole truth.

Proposal–An End to the 1031 Exchange

A 1031 tax-deferred exchange is a tool that allows a seller of real estate to avoid paying capital gains tax and taxes due from depreciation recapture so long as all proceeds are invested in a “like kind” property. Those in the real estate industry argue the 1031 tax-deferred exchange is a part of the tax code that really makes sense. The argument is a pretty simple one– without this portion of the tax code, investors would have to pay capital gains taxes every time a property is sold, potentially wiping out large amounts of equity otherwise reinvested in real estate and vital to economic growth and job creation.

However, deferred taxes represent a huge potential revenue drain to the government, and the tax reform proposal has a simple solution to it. It abolishes the 1031 tax-deferred exchange. The most recent proposal authored by Dave Camp (R-MI) calls for the elimination of this section of tax code after December 31, 2014.

Proposal–New Depreciation Timeframes and Recapture

The Camp Tax Reform Draft also calls for modification to depreciation time frames. Depreciation effectively recognizes that property deteriorates and this is reflected in the form of a tax deduction the IRS allows to be taken in equal amounts over a period of time. Currently, residential real estate is depreciated over a period of 27.5 years, commercial real estate (including most investment real estate) over a period of 39 years, and leasehold improvements over 15 years. Under the current proposal, all real estate purchased and leasehold improvements made after 2014 would be treated the same—with a a depreciation schedule of 40 years.

Industry experts argue that user needs and preferences as it relates to real property is ever changing and, as a result, the actual economic and functional life of commercial real estate is already much less than the 39-year and 15 year schedules provided. Any measure that increases the timeframe for depreciation is a step in the wrong direction.

In addition, the Camp Plan includes a change for the way depreciation is recaptured. Under the current tax code, when property is sold for more than its depreciated value, it gets recaptured at a 25 percent tax rate. For those in a high tax bracket, this represents a substantial tax savings. However, this special Section 1250 tax rate for depreciation recapture is also on the chopping block, and real estate depreciation recapture will be taxed like other forms of recapture — at your marginal income tax rate.

Seemingly, A Bunch of Chicken Littles

Recent tax reform proposals were being spearheaded by Max Baucus (D-MT), who was just sworn in as the ambassador to China and left Congress. Many thought this marked the end of comprehensive tax reform, but the release of Representative Camp’s proposal in late February has revived the conversation—if only to say that it will fall flat. Most seem to believe, despite the red flag emails making their way into the inboxes of investors, that tax reform, including abolition of the 1031 and changes to depreciation, is not happening for reasons including a lack of Presidential enthusiasm, gridlock within Congress, and anticipated Congressional shifts. In reality, it seems unlikely these components will gain traction because the groups impacted by the changes are among the wealthiest and most powerful in the Nation.

Public interest is generally aroused by dramatic events and in the world of commercial real estate, the 1031 exchange and depreciation are fairly compelling topics. While these tax reform proposals are in committee, and might never be enacted, there is a change coming that will have a significant impact on commercial and investment real estate. Until next month.