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Are you unknowingly supporting a system which increases income inequality and weakens communities? The answer might surprise you.

This article is Part II of a series on taxation and income inequality in the U.S. – for Part I of the series, see The U.S. tax system: Inequality’s best friend.

Taxes on gains and 1031 transactions

Profit is a beautiful thing for everyone – or at least it has that potential. A profit is made when an asset is sold for more than was originally paid for it, taking into account transactional costs and depreciation.

Depreciation comes into play when an asset is held for at least 12 months due to cost recovery deductions returning invested capital without taxation. However, depreciation is taxed on a sale as unrecaptured gain at a maximum rate of 25%. If any amount remains after taking into account the unrecaptured gain, this is considered a capital gain, a part of the profit, also subject to taxation.

In other words, the net price on a sale (sales price sans transactional costs) minus the cost basis (the original purchase price along with any improvement costs incurred to counter the effects of depreciation) equals the capital gain. A capital gain– profit – is treated differently for tax purposes than ordinary income, and is currently taxed at a much lower rate.

Annual income from portfolio investments, including management-free income property with triple-net leases and interest earned on bonds and notes, also is not subject to capital gains tax, but is taxed at ordinary rates unless classified as dividends or tax exempt.

Related article:

first tuesday Tax Benefits of Ownership, 3rd Ed, Chapter 6: Income tax categories

Today, most sellers of real estate do not fret over paying capital gains tax, as sellers holding property for fewer than 20 years will not receive much of a profit on the sale of their property due to the huge price reductions occurring in this financial crisis climate. However, during the real estate bubble, steeply elevating prices made capital gains tax an issue that investors did their best to skirt, and will become an issue again in another five to eight years as the real estate industry laboriously works its way to full recovery.

Here, §1031 transactions allow real estate investors to put off incurring any capital gains (or unrecaptured gain) tax they would owe on a sale, as long  as they:

  • re-invest the net proceeds of a sale in §1031 property within the specified period after selling investment or business-use property;and
  • do not constructively receive the net sales proceeds.

A 1031 transaction is the tax deferment method of choice for those investors who plan to remain in real estate, as the profit and basis are simply carried forward to the replacement property in each transaction – until the investment is finally liquidated on a sale without reinvestment at which time taxes on the final profit are due.

If the combined capital gains tax rate ceiling of 15% (18.8% for those who must pay the additional 3.8% under the healthcare bill)increases in the coming years, then §1031 exchanges will likely see an early resurgence for those businessmen and investors who desire to remain and reinvest in real estate. The capital gains tax will most likely revert to 20% in 2013 as Bush-era tax cuts expire. The past ten years have been the only time the capital gains tax limit has been below 20%, its historical maximum being 30%, compared to the maximum 35% tax (plus an additional .9% tax on income in excess of the thresholds set by the healthcare bill) on ordinary income for the wealthiest.

The 400 richest taxpayers in 2009 received roughly half of their income from sources permitting capital gains treatment, and less than 9% from salary and wages. Thus, the majority of the wealthiest individuals’ earnings were taxed at a lower rate than were the earnings of the average taxpayer, simply due to how their earnings were generated – through passive and portfolio investments instead of paychecks for actually working.

Issues of fairness aside, the results of low tax rates on capital gains have been detrimental for the U.S. economy, contributing to the widening income disparity and government debt prevalent today – the rich versus the poor issue. Interesting that it is the poorer among us that insist upon dogma that enable the rich to get richer, and the poor, poorer.

Income inequality: consequences for real estate

Tax loopholes like the capital gains tax limit and the §1031 exchange are part of maintaining a healthy economy, when applied properly. However, when the capital gains tax limit is set too low, an unstable economic situation results.

To begin to explain, taxes support communities through transfers from the U.S. Treasury, as well as most public services every single resident, rich or poor, demands. Property taxes also play a role here, but again old wealth pays less and the newcomer pays much more.

It’s no coincidence that the most desirable communities in California house our wealthiest residents. The reason:higher income earners contribute more to the community coffer, by voluntarily supporting community events, safe parks, clean sidewalks, better school districts and other infrastructure amenities.Thus, according to the time-tested adage “location, location, location,” homes in desirable communities are valued more than those located elsewhere. La Jolla comes to mind, as does Montecito.

(Actually, the original saying  was a more instructive chant of “Time, price and location,” but only “location” was heard.)

By applying this logic on a national scale, we can see the ability to improve our collective standard of living is directly affected by taxes.

Consider a flock of sheep in a cold mountain town. The town members need a way to stay warm in the winter, and they have three options:

  • The Greedy Option: slaughter the sheep, enjoying the warmth of their wool and the bonus of lamb chop on the side;
  • The Smart Option: shear the sheep, collecting enough wool to stay warm while leaving enough wool coating for the sheep to get through the winter just fine;
  • The Stupid Option: let the sheep keep their extra wool while the townspeople freeze to death.

Hopefully, you have figured out the sheep are the wealthiest taxpayers and the freezing townspeople are everyone else. Wealthy earners, the sheep,  produce more income than they need, thus they can (and do) shift a portion of their wealth to support community and federal transfer programs (the banking system, food and shelter programs, medical care and other society fabric safety-net actions). The extremely wealthy, we must quickly add,often voluntarily share their good fortune through charity and endowment programs.

Regardless of the level of taxes, the wealthy always continue to make money. But why should they share it to support the very system that sustains their way of earning? In order to continue receiving returns, those who benefit from our system of governance need to aggressively support it, or move somewhere else, the wealthy rentiers not (yet) being a protected class. Foreigners in exchange would be happy to willingly pay whatever taxes our system imposes on them so long as they could open businesses and operate in our country.

Take action

Taxation and real estate ownership are a delicate balance of looking out for one’s own interests and supporting the community – one cannot thrive without the other’s success.However, there are those who want only big sales (the instant gratification type), stimulated by low tax limits of all sorts, local, state and national.

Rather, they might consider a healthy, stable housing climate, assisted by pervasive attractive communities funded sufficiently by government revenues.

Members of the National Association of Realtors (NAR) recently lobbied the federal government to maintain the current capital gains tax limitation. According to FollowTheMoney.org, NAR has donated $4.6 million (coming primarily from member dues) to political parties and candidates since 2011 to further their political goals, such as the low capital gains tax limit.

If you are a paid member of NAR, speak up: should your membership dues be used to support increased income inequality for working Americans?