Section 1031 of the United States Internal Revenue Code

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FISHMANPET
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Re: Downtown Minneapolis General Topics & Development Map

Postby FISHMANPET » July 14th, 2015, 2:13 pm

Also I don't think there's anything inherently immoral about following the tax code as written and intended. Exploiting loopholes maybe is immoral, openly flaunting the tax code certainly immoral, but I don't think following it as intended can be immoral.

You could even go so far as to think the code itself is wrong or immoral (like the Mortgage Interest deduction) but still take advantage of it without being immoral or even a hypocrite. If it's there, use it. If you don't like it, lobby against it. The two aren't necessarily related.

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Re: Downtown Minneapolis General Topics & Development Map

Postby TroyGBiv » July 14th, 2015, 2:31 pm

I totally agree with you on this! If it is law it is legal... If it is bad policy or bad law... change it. The problem with deferment is that much of our cities operating budget relies on that annual income the maintain school funding etc. Some of these deferred options put undue strain on other parts of our city.

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Re: Downtown Minneapolis General Topics & Development Map

Postby FISHMANPET » July 14th, 2015, 2:34 pm

I don't believe much of our cities operating budget relies on federal capital gains taxes. It relies on property taxes, which these buildings continue to pay.

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Re: Downtown Minneapolis General Topics & Development Map

Postby twincitizen » July 14th, 2015, 3:20 pm

I totally agree with you on this! If it is law it is legal... If it is bad policy or bad law... change it. The problem with deferment is that much of our cities operating budget relies on that annual income the maintain school funding etc. Some of these deferred options put undue strain on other parts of our city.
It sounds like you are describing local Tax Increment Financing (TIF). In this case, we're talking about federal (and maybe state) capital gains taxes. Nothing to do with local funding at all. We are talking about a company or person selling some buildings and using that money to buy other buildings, without taking a capital gains hit in between. Even in this very specific case you clearly can see how it encourages reinvestment in other older buildings (Ned Abdul's specialty). This is a good thing. They (or their personal or corporate heirs) will eventually pay capital gains taxes at some point.
Let's all read this again:
1031 exchanges aren't tax avoidance, they just delay taxes. The idea with 1031 exchanges is that the substance of the owner's investment really doesn't change when similar business properties are swapped. Along with delaying taxes now, the tax basis in the old properties transfer to the new. Let's say a developer bought a small rundown office building for $4 million, invested $2 million in rehab, worked hard to get a stable roster of tenants and increased the property value to $11 million. If the developer sold the property he'd owe tax on $5 million in capital gains. Instead of selling the developer could buy a larger but rundown property for $12 million. The basis in the new property is $7 million ($6 million from old property and $1 million in cash). It's smart planning strategy to have capital gains at the ready in case an investment fails.
And I'll add, all the while paying property taxes on those buildings, increasing the property tax base by improving those buildings, etc.

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Re: Downtown Minneapolis General Topics & Development Map

Postby min-chi-cbus » July 14th, 2015, 4:03 pm

Also I don't think there's anything inherently immoral about following the tax code as written and intended. Exploiting loopholes maybe is immoral, openly flaunting the tax code certainly immoral, but I don't think following it as intended can be immoral.

You could even go so far as to think the code itself is wrong or immoral (like the Mortgage Interest deduction) but still take advantage of it without being immoral or even a hypocrite. If it's there, use it. If you don't like it, lobby against it. The two aren't necessarily related.
I thought I already addressed this...
I mean it's morally wrong....I understand why they do it, I don't understand why it's allowed.
Perhaps I misread the intent of some of you, but I don't think I was that far off. It doesn't matter though, my underlying point wasn't that Ned Abdul and Swervo Development were inherently evil because they followed the tax codes as they currently exist (I mean, I'm not a huge fan of the rules but I can see why a for-profit company would try to minimize their taxes. And I honestly have little clue on which taxes benefit cities the most -- land taxes, taxes from operations, or other taxes -- so you may have a good point there and I just had to learn about it the hard way). My point was that it seems that the individual and under-educated/under-privileged are responsible for a larger proportion of taxes than they maybe should be, and more than I previously thought. And it also seems that corporations -- who make the most money and can best afford to pay their taxes -- aren't taxed as much as they could be, not due to the accounting codes and laws, but because of their ability to exploit loopholes. It is my position that just because they CAN exploit a loophole, doesn't mean they should, and it ultimately defers the responsibility to others (the taxes have to be paid by somebody) and it doesn't really ultimately help the community in which they operate. I'm against the loopholes more than anything, though I totally get why somebody would take advantage of that situation....few of us wouldn't.
Last edited by min-chi-cbus on July 14th, 2015, 4:06 pm, edited 1 time in total.

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FISHMANPET
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Re: Downtown Minneapolis General Topics & Development Map

Postby FISHMANPET » July 14th, 2015, 4:06 pm

Ok, I don't disagree with any of that, but this isn't a loophole anymore than going under the speed limit is a "loophole" for not getting a speeding ticket. He's not taking advantage of some unintended consequence of the a 1031 exchange here, he's using a 1031 exchange for the literal purpose it was designed for.

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Re: Downtown Minneapolis General Topics & Development Map

Postby min-chi-cbus » July 14th, 2015, 4:09 pm

Ok, I don't disagree with any of that, but this isn't a loophole anymore than going under the speed limit is a "loophole" for not getting a speeding ticket. He's not taking advantage of some unintended consequence of the a 1031 exchange here, he's using a 1031 exchange for the literal purpose it was designed for.
And maybe I just don't quite understand the purpose of the rule, but perhaps if I look it up and see an example on a spreadsheet I'd get it better. I don't get what the benefit of deferring the taxes is if they ultimately have to pay them anyway. I'll think it over some more though.

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Re: Downtown Minneapolis General Topics & Development Map

Postby FISHMANPET » July 14th, 2015, 4:18 pm

If an investment fails and you lose more than $3000 you can't just deduct that number from your income. Corporate taxes are trying to tax profits, not actual income. If you make a million one year but lose a million next year, you're profit is zero, so you don't want to pay taxes like your profit was $1 million one year and -$3000 the second year. So you defer that $1 million in capital gains and apply it to the $1 million in capital loss and it all balances out.

And I'm sure I've screwed that up and VAStationDude will correct me. My knowledge of capital gains is the $20 or so I make every year in my mutual fund.

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Re: Downtown Minneapolis General Topics & Development Map

Postby VAStationDude » July 14th, 2015, 7:07 pm

You're mostly correct. The $1 million gain and $1 million loss example is 100% right. Real estate investors likely don't pay corporate tax. Most real estate developments are held in a limited liability company and treated like a partnership for tax purposes. Income, losses, capital gains and capital losses flow through a partnership to the partners. The income and losses are reported on a 1040 just like your wage, interest, capital gains and self employment income.

I just thought of another couple reasons why 1031 exchanges are beneficial. In my previous example the savvy real estate investor bought a property, rehabbed it and filled it with tenants. He took a big risk and absolutely hit a home run. Now that the building is leased it will likely generate steady profits from rent. Our savvy real estate investor isn't in the business of holding real estate. He's a developer. He wants higher risk rehabs and development. Let a pension fund or REIT buy the successfully renovated property. If he sold the property outright a substantial chunk of the profits (24.85% if he's in the highest MN tax bracket) would go to pay income tax. It would behoove our investor to do a 1031 like kind exchange, delay paying the taxes, use the capital that would go to the tax man in the new investment and carry over the low basis from the old property to the new. The low basis also helps the investor better avoid a realizing a larger loss and the -$3000 a year capital loss limitation if his next investment doesn't work out.

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Re: Downtown Minneapolis General Topics & Development Map

Postby Viktor Vaughn » July 14th, 2015, 8:33 pm

I can't believe businesses dodge capital gains tax in the first place.....it's only 15%, isn't it? .
That's historically been true, and still is if you lived in a state without an income tax and your income is less than the $250K cutoff. However, if you report capital gains on top of high ordinary income, the rate can be a lot higher.

If your AGI is over $250K, then your capital gains rate is 20%. You'd add 9.85% marginal rate for Minnesota income taxes (MN doesn't have preferential tax treatment for capital gains). Plus with income at that level, you'd pay the Net Income Investment Tax of 3.8% (a tax on passive income to pay for the ACA). So after a deducting your state taxes on your federal tax return (20% x 9.85%), the top marginal rate would be about 32%.

I'm not convinced capital gains should have preferential tax treatment at all, but it's no longer accurate to say the wealthy pay only 15% on capital gains. The tax code still taxes work at higher rates than wealth, but progressive tax laws have narrowed the gap in the last few years.

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Re: Downtown Minneapolis General Topics & Development Map

Postby LakeCharles » July 14th, 2015, 8:40 pm

I just thought of another couple reasons why 1031 exchanges are beneficial...
But why exactly do we allow that to happen? If I make $80k a year in my whatever job, I don't get the option of not paying income tax, and pouring the money back into an investment, and seeing what happens.

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Re: Downtown Minneapolis General Topics & Development Map

Postby Viktor Vaughn » July 14th, 2015, 8:52 pm

If he sold the property outright a substantial chunk of the profits (24.85% if he's in the highest MN tax bracket) would go to pay income tax. It would behoove our investor to do a 1031 like kind exchange, delay paying the taxes, use the capital that would go to the tax man in the new investment and carry over the low basis from the old property to the new. The low basis also helps the investor better avoid a realizing a larger loss and the -$3000 a year capital loss limitation if his next investment doesn't work out.
It's common for developers to have a regular stream of negative income from passthrough operating entities and entities owning real estate. They suffer losses developing projects and have tax losses after deducting depreciation even from properties with positive cash flow. A developer's payday is when they sell the property. Since they're able to defer that gain indefinitely, they may not ever pay significant taxes despite living life like a tycoon. I think it's reasonable to tax them on that windfall when they sell property. Then they can reinvest the after-tax proceeds into their next project, just like the rest of us invest after-tax dollars.

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Re: Downtown Minneapolis General Topics & Development Map

Postby BoredAgain » July 14th, 2015, 10:51 pm

I just thought of another couple reasons why 1031 exchanges are beneficial...
But why exactly do we allow that to happen? If I make $80k a year in my whatever job, I don't get the option of not paying income tax, and pouring the money back into an investment, and seeing what happens.
I am not a tax expert, but I think that you do have this option. It is called a 401K and you can dump money in there tax free. You still probably take some money out as income for other expenses, but so do developers in terms of personal income.

Once you reach retirement, you pull money out of your 401K and pay taxes on it then, but developers do the same once they sell off property, but don't re-invest that money.

It's not exactly the same, but it is a corollary. There are just different tax rules for companies than there are for individuals. No matter what the supreme court may say, corporations aren't people.

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Re: Section 1031 of the United States Internal Revenue Code

Postby Viktor Vaughn » July 14th, 2015, 11:06 pm

Pre-tax retirement contributions are available to anyone who can afford to make them, but they limit how much you can defer. A developer can max out his retirement contribution, but this is about millions in taxes deferred beyond those limits.

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Re: Section 1031 of the United States Internal Revenue Code

Postby BoredAgain » July 15th, 2015, 7:31 am

Pre-tax retirement contributions are available to anyone who can afford to make them, but they limit how much you can defer. A developer can max out his retirement contribution, but this is about millions in taxes deferred beyond those limits.
Deferred, but only until they stop re-investing. They do pay out eventually.

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Re: Section 1031 of the United States Internal Revenue Code

Postby bubzki2 » July 15th, 2015, 7:34 am

Unless they die first, right? Then one's basis steps up IIRC. Defer, defer, defer, die, as my tax professor liked to say (he's actually a 1031 specialist).

If the tax code gets us nice things like the Armory renovation, I can live with the seemingly odd rules.

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Re: Section 1031 of the United States Internal Revenue Code

Postby Viktor Vaughn » July 15th, 2015, 8:22 am

Yes, I think the goal the deferring is to avoid the taxes all together. As you defer gain from one property into another that gain just grows, increasing the incentive not to realize it. Then as bubzki2 says, heirs get a step up in basis to the fair market value on inheritance. So they can turn around and sell it the next day, and not owe any tax at all. This is known as the "Trust Fund Loophole" and Obama proposed fixing it in this year's State of the Union, but that's not gonna happen with a Republican Congress.

I don't consider Like Kind Exchanges among the most egregious tax rules that stack the deck in favor of the wealthy. Farmers are heavy users of 1031 when they upgrade combines or swap farm land. Any attempt to eliminate this rule would be met with farmer's pitchforks.

Yet, if the tax code was to be overhauled based on the principals of simplicity and fairness, I think these rules would have to be scrapped.

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Re: Downtown Minneapolis General Topics & Development Map

Postby min-chi-cbus » July 15th, 2015, 8:24 am

If he sold the property outright a substantial chunk of the profits (24.85% if he's in the highest MN tax bracket) would go to pay income tax. It would behoove our investor to do a 1031 like kind exchange, delay paying the taxes, use the capital that would go to the tax man in the new investment and carry over the low basis from the old property to the new. The low basis also helps the investor better avoid a realizing a larger loss and the -$3000 a year capital loss limitation if his next investment doesn't work out.
It's common for developers to have a regular stream of negative income from passthrough operating entities and entities owning real estate. They suffer losses developing projects and have tax losses after deducting depreciation even from properties with positive cash flow. A developer's payday is when they sell the property. Since they're able to defer that gain indefinitely, they may not ever pay significant taxes despite living life like a tycoon. I think it's reasonable to tax them on that windfall when they sell property. Then they can reinvest the after-tax proceeds into their next project, just like the rest of us invest after-tax dollars.
That was my thinking (mostly -- you guys seem to understand accounting and taxes much better than I do or ever will). From the example from VAStationDude, I didn't understand where this impending loss is coming from, nor why the developer is banking on it in the future and deferring capital gains by using this 1031 rule. Who's to say there will ever be a loss to offset? But it sounds like you're saying that it's common to have a steady stream of losses from even profitable operating assets, so that sort of made sense then to apply capital gains towards those losses to lower their tax burden.

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Re: Section 1031 of the United States Internal Revenue Code

Postby min-chi-cbus » July 15th, 2015, 8:28 am

Yes, I think the goal the deferring is to avoid the taxes all together. As you defer gain from one property into another that gain just grows, increasing the incentive not to realize it. Then as bubzki2 says, heirs get a step up in basis to the fair market value on inheritance. So they can turn around and sell it the next day, and not owe any tax at all. This is known as the "Trust Fund Loophole" and Obama proposed fixing it in this year's State of the Union, but that's not gonna happen with a Republican Congress.

I don't consider Like Kind Exchanges among the most egregious tax rules that stack the deck in favor of the wealthy. Farmers are heavy users of 1031 when they upgrade combines or swap farm land. Any attempt to eliminate this rule would be met with farmer's pitchforks.

Yet, if the tax code was to be overhauled based on the principals of simplicity and fairness, I think these rules would have to be scrapped.
Again, this is what I was thinking: when do the deferrals stop, if ever? There must have been a different intent of 1031 when it was originally set up.

From this link explaining Like-Kind Exchanges http://www.irs.gov/uac/Like-Kind-Exchan ... ction-1031 it doesn't sound like investors are allowed to just reinvest their capital gains:
To qualify as a Section 1031 exchange, a deferred exchange must be distinguished from the case of a taxpayer simply selling one property and using the proceeds to purchase another property (which is a taxable transaction). Rather, in a deferred exchange, the disposition of the relinquished property and acquisition of the replacement property must be mutually dependent parts of an integrated transaction constituting an exchange of property.


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