You Now Can Trade Up Your Violin, but Not the Bow or Case – New Things to Consider in Section 1031 Exchanges After the 2017 Tax Law

By Elizabeth A. Whitman

In my February 2017 blog post “Sizing Up in Violins and Investment Real Estate,” I discussed how buying increasingly larger (and more expensive) violins compares to real estate investments. I discussed how starting with a 1/32 size, I had purchased a series of violins and then “traded up” to the next size through a 7/8 size violin. Each time, the primary purchase was a violin, but we also had to purchase a similarly-sized bow, case, and accessories in order to play the larger violin.

A real estate investor might start small, with a single duplex and eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings. In those instances, although the primary purchase was real estate, each purchase would come with a certain amount of personal property in the form of appliances, furnishings, supplies, and other equipment necessary to operate the real estate.

Comparing a real estate transaction to a violin purchase, purchasing the violin would be akin to purchasing the real property, and purchasing the bow and case would be more like the personal property that is purchased with the real estate investment.

My previous blog discussed how there are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.

Since 1921, one thing that has helped real estate investors accomplish growth while deferring taxes is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property. Over the years, Section 1031 has evolved, but generally, those changes have provided clarity or expanded the opportunities to defer taxes upon a sale and reinvestment.

The Tax Cuts and Jobs Act signed into law in December (2017 Tax Act) introduces new rules on 1031 like-kind exchanges by limiting the types of assets eligible for Section 1031 exchange. As a result of these changes, effective January 1, 2018, only real estate exchanges will be eligible for tax deferral. Using the violin “trade up” comparison, under the 2017 Tax Act, the violin could be traded for a larger one, but it would not be possible to “trade up” the bow or case.

Most real estate sales include the sale of at least some personal property: from refrigerators in an apartment complex to common area furnishings in an office building or maintenance equipment in a shopping center. Most of that personal property can be depreciated over just a few years or sometimes, expensed entirely under what is known as a Section 179 Deduction[1] which allows a limited amount of capital expenditures to be deducted entirely in the year in which they are made. Therefore, by the time the personal property is sold with the real estate, it likely has a zero basis. As a result, under the 2017 tax law, any amount of the sale price allocated to the personal property is very likely to be taxed either as capital gains or recaptured depreciation.

On the bright side, for many real estate asset classes, either there isn’t much personal property or the personal property doesn’t have much value in its used condition. For instance, even if there are 150 refrigerators in an apartment complex, if each of them is six or seven years old, the sale price isn’t going to be very high, so the resulting taxes won’t be material. However, there are situations where a real estate sale might include more valuable trade fixtures, equipment or machinery, for which a reasonable sale price allocation would result in significant taxes.

Where the potential tax liability for a sale involving both real estate and personal property is significant, careful planning can help to reduce the tax burden of these tax law changes. Strategies to explore include the following:

Consider leasing personal property. Payments made for a true lease (one that is not a disguised sale or installment purchase) can be deducted when made, providing a similar tax liability to depreciation (or a Section 179 deduction). Of course, with a lease, the lessee would not acquire any ownership in the personal property. If the lessee plans to sell the real estate to which the personal property relates and dispose of the lease obligation at the same time, the lease would need to be assumable by the buyer of the real estate or cancellable.

Offset Capital Gains Against Capital Losses. If the taxpayer has capital losses, then many capital gains can be offset against those losses so that no tax is paid. Because real estate assets may be held inside of a separate legal entity, the capital gains and capital losses must be allocable to the same ultimate taxpayer for this strategy to be effective.

Assign Property Values to the Personal Property Upon Sale. There is a natural tension between buyers and sellers when there is a sale of mixed real estate and personal property. Buyers tend to want to purchase price to be as heavily allocated to personal property as possible, both because they can depreciate personal property more quickly and because in some states, a high allocation to real property may result in an increase in real estate taxes or a high transfer tax bill.

Sellers sometimes agree to the buyers’ values in order to move forward with the deal. However, the reality is that many times, used personal property has little to no value in the marketplace – if you look on craigslist for instance, a used refrigerator or other appliance in good condition may sell for no more than 15-20% of the new value, and many times, the personal property sold with investment real estate has been heavily used. Proper valuations of the personal property can result in a smaller portion of the purchase price being allocated to personal property subject to capital gains taxes.

On a related note, the 2017 Tax Law may have adverse consequences for professional violinists. Suppose a professional violinist starts with a nice, $10,000 modern Italian violin, which has appreciated to $40,000 over a period of many years while the violinist saved up to “trade up” to a $150,000 Vuillaume[2] violin.  Under the 2017 Tax Law, this violinist is out of luck; since a violin is personal property, under 2017 Tax Law that violinist now may have to write a check to the IRS for the gain on the sale of the $40,000 Italian instrument acquired for $10,000 many years before.

___________________________

[1]  The 2017 tax law also modified the Section 179 deduction limitation so that many taxpayers will be able to expense up to $1 mil. per year in capital purchases instead of depreciating those items over time.

[2]  Music Geek Fact: Jean-Phillipe Vuillaume was a 19th century French violin maker. He started his career in the shop of Francis Chanot, who had a reputation for forging violins. Before long, Vuillaume was copying violinists made by Stradivari and Guarneri del Gesu, two 18th century Italian master violin makers, whose instruments were already quite valuable. Vuillaume’s skill was so great that some of his instruments reportedly were mistaken for the originals. Vuillaume turned away from forgery and instead produced violins he acknowledged as copies (the difference between forged and copied violins being only whether the lack of authenticity is disclosed).  Ironically, after Vuillaume won violin competitions in his own right, violins bearing his name became some of the most commonly forged (or shall we say “copied”) in the late 19th century. Today, a Vuillaume might sell for more than $250,000, with his copies of the famous “Messiah” Stradivari violin being among the most desirable.

©   2017 by Elizabeth A. Whitman

For more information, please contact Elizabeth A. Whitman at (301) 664-7713 or eawhitman@mirskylawgroup.com.

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.

SIZING UP IN VIOLINS AND INVESTMENT REAL ESTATE

If you have ever attended an elementary school instrumental music concert, you may need your parental pride to outweigh the general cacophony that is inflicted on your ears. Sometimes, however, you may find a group of violins that sound pretty good. Why is that?

Well, for technical reasons, string players can start younger[1]. As supply meets demand, violins can range from a 1/32 size up to full size.  Therefore, a child can start playing the violin on a tiny instrument at a very young age and “size up” on violins as he/she grows.

There are two strategies for obtaining violins for a child: rent or own. If you rent, you just pay each month for your child’s entire career.  If you choose to buy the violins, you will keep buying and disposing of increasingly more expensive violins.  I looked at the math and decided to buy my son’s violins.

My son started at age three playing a 1/32 size violin, which with an eight-inch body looked more like a toy than a violin. At age five, when he moved to a 1/10 size, we also found a need to move up a step in quality (and therefore, price) with each size increase.  A few months ago, my son traded in his ¾ size violin for a 7/8 size instrument, which is valued at 20 times the price we paid for that original 1/32 size violin nearly nine years before.

When we made the most recent violin purchase, I realized how our “investment” in violins is like real estate investment. A real estate investor might start small, with a single duplex.  That duplex might be sold and the money reinvested in a four-plex, and the four-plex might in turn, be sold and the proceeds reinvested in a more expensive three-story office building.  Eventually, through a series of purchases, sales, and reinvestments, the real estate investor may own multiple large apartment complexes, office buildings, or even high-rise mixed-use buildings.

Unlike with violins purchased for my son, a real estate investor has to think about taxes with every “trade up.” There are two ways that an investor might owe taxes upon sale of investment real estate – increase in value (i.e. the property is sold for more than what is invested in it) or a “recapture” of depreciation expenses that the investor took while he/she owned the investment real estate.  Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.

One thing that helps real estate investors accomplish growth in is to use a Section 1031 exchange to defer taxes each time they sell an investment property and reinvest the proceeds in another “like-kind” investment property within 180 days.

When it was first created in 1921, a Section 1031 exchange required a literal swap of the two properties, as would occur if my son were to literally trade in his small violin at the violin shop for a larger sized violin.   For a direct swap, tax deferral makes a lot of sense.  It can be difficult to determine the “sale prices.”  Plus, unlike a sale and reinvestment, a sale doesn’t result in a cash payout from which taxes could be paid.

Therefore, over the years, Section 1031 exchanges have evolved so that they are more useful to real estate investors.

For instance, another option with violins, is to sell the smaller violin to another student and then use the money to buy the larger sized violin from the violin shop. Likewise, a real estate investor might choose to sell that duplex to Company A and use the proceeds to buy the four-plex from Company B.

For the past 30+ years, the tax law has allowed real estate investors to use what is known as a “qualified intermediary” to do the real estate equivalent by for instance, exchanging an apartment building sold to Company A with an office building purchased from Company B.   Without going into the detailed rules for this 1031 exchange, this would roughly equivalent to selling the smaller violin to another student, then putting the proceeds of the sale in a special savings account that could only be used to buy a new violin, once the desired instrument was located.

1031 Exchanges, however, are seen by some as a tax loophole for real estate investors. The Republican tax proposal “A Better Way” would significantly change the tax laws, including those on investment real estate. The proposal includes a full and immediate expensing of investment in place of depreciation.

Although this proposal might simplify the tax laws, it is likely to complicate the tax situation for many real estate investors. 1031 exchanges are not specifically mentioned in “A Better Way,” but some believe that 1031 exchanges might be abolished along with depreciation.  If that were to happen, real estate investors likely would be taxed on their proceeds upon sale of their real estate.  This would limit available cash for real estate investors’ to “trade up” and potentially could slow down the recovery of the real estate market.

Therefore, although it seems likely that there will always be a crop of younger violinists in need fractional-sized violins as you “trade up” to larger instruments, tax laws may not always make it as easy to “trade up” your real estate investment.

© 2017 by Elizabeth A. Whitman

________________________

[1] Geek fact: A partial explanation is that strings of different length can reach the same pitch by changing the tension, while wind instruments require a certain length of the air column to produce a pitch.  So if you want to start your five-year-old on a bassoon, you may need to stretch him a bit first. Also, wind instruments require a developed mouth and certain number of permanent teeth, which are not required for string instruments.

Disclaimer: The content of this blog is intended for informational purposes only. It is not intended to solicit business or to provide legal advice. Laws differ by state and jurisdiction. The information on this blog may not apply to every reader. You should not take any legal action based upon the information contained on this blog without first seeking professional counsel. Your use of the blog does not create an attorney-client relationship between you and Mirsky Law Group, LLC.