Republicans may change tax code to make property swaps less attractive

Defenders of tax-deferred exchanges say small investors may lose incentives to upgrade their holdings.

By Kenneth R. Harney January 25

The small-scale owners of millions of rental homes, parcels of investment land and income-producing commercial and business real estate may not know it, but one of their key financial planning and tax tools is in danger of disappearing on Capitol Hill.

House Republicans are working on a proposal that, as part of an overall streamlining of the Internal Revenue Code and a reduction in tax rates, may eliminate or seriously restrict the use of tax-deferred exchanges – property swaps – under Section 1031 of the code. President Trump has identified tax revision as one of his top priorities, and legislation is expected to move quickly in the new Congress.

In a tax-deferred exchange, owners can postpone recognition of gains on investment real estate when they swap one property for another of “like kind.” The capital gains tax that would otherwise be due gets deferred until the owner sells the replacement property and receives cash.

Under Section 1031, which has been part of the tax code since 1921, a rental house in Santa Barbara, Calif., might be exchanged for an investment duplex in suburban Chicago. Oklahoma farmland could be exchanged for rental condos in Washington, Boston or Miami. Exchanges are also used to further environmental protection objectives, such as through swaps involving conservation easements to preserve habitat and prevent future development.

To qualify for tax deferral, exchanges must follow a detailed set of IRS rules specifying the timing for identifying replacement properties and transaction closing deadlines. An entire industry of what are called “qualified intermediaries” exists to facilitate exchanges by escrowing proceeds and administering transactions to comply with IRS rules. Fixer-upper houses and other real estate held for short periods and then flipped to new purchasers do not qualify for tax-deferred exchanges, nor do owner-occupied residences.

Loss of the ability to use an exchange would be a significant blow to “Mom and Pop” and other small-scale realty investors. According to a study posted on the website of the National Rental Home Council, there were 15.7 million rental homes in the United States as of 2015, and 99 percent of them were owned by noninstitutional investors. A study by professors at the University of Florida and Syracuse University estimated that most exchanges involve relatively small properties; in 2011, 59 percent had a sale price of less than $1 million.

Bill Horan of Realty Exchange Corp. in Gainesville, Va., told me about recent transactions that illustrate some of the objectives of tax-deferred property swaps. In one, a rental property owner exchanged it for two Dollar General stores. The owner “didn’t want to be a daily landlord anymore,” which involved hands-on management duties and liabilities, Horan said. By rolling his rental housing gains and equity into “triple net” leased retail properties, where the tenants essentially are responsible for everything, he was able to simplify his life, diversify his portfolio and potentially make greater gains in the future with retail real estate.

Another small investor swapped a rental home in Virginia for a rental condo in Fort Myers, Fla., where he intends to move for retirement. “He wanted to own property near where he’s going to live,” Horan said. Because the Fort Myers unit cost $412,000 and the rental home he relinquished was valued at $525,000, the investor ended up paying a modest amount of capital gains taxes.

Exchanges have been on congressional tax writers’ hit lists before, in part because they generate tax “expenditures” – losses of otherwise immediately collectible revenue for the federal government. In December 2015, the congressional Joint Committee on Taxation estimated that during fiscal 2017, exchanges would generate tax expenditures of $11.7 billion attributable to corporations and $6 billion attributable to individual taxpayers. For the same year, by comparison, revenue losses caused by deductions for mortgage interest and local property taxes by individual homeowners were much larger: $84.3 billion and $36.9 billion, respectively.

Exchange proponents, such as Suzanne Baker of Investment Property Exchange Services in Chicago, argue that most of the deferred taxes ultimately are collected when properties get sold for cash and that exchanges stimulate economic activity – redevelopment and upgrades of properties, for example – that would not occur if owners faced immediate taxes on their gains and therefore simply sat on them.

Bottom line: If you own investment real estate and have contemplated a Section 1031 exchange, be aware: There’s a significant possibility that tax revisions could knock your plans off track. Keep a close eye on what’s happening, because it could happen fast.

Update: As noted as a possibility in last week’s Nation’s Housing column, the Trump administration has suspended indefinitely the reduction in FHA home mortgage insurance premiums that had been scheduled to take effect Jan. 27.

Premium reduction is good news – but might be fleeting

KENNETH R. HARNEY on Jan 20, 2017

Published in https://www.arcamax.com/homeandleisure/consumer/thenationshousing/ The Nation’s Housing

WASHINGTON – Here’s some potentially good news for anyone seeking a low down payment mortgage without high credit scores- The Federal Housing Administration is cutting its mortgage insurance premium charges, making its loans a little more affordable.

But if this sounds attractive, be aware that it could be temporary. Although the Obama administration scheduled the reduction to take effect on new FHA loans insured on or after Jan. 27, there could be a problem. Key House Republicans have objected to the cost reduction and are pressing the incoming Trump administration to reverse it. At his confirmation hearing, Ben Carson, nominee to be the new secretary of the Department of Housing and Urban Development, said if confirmed, he would “examine” whether it’s a good move or not.

The premium reduction is not huge – just one quarter of one percent off the previous charge – but it will lower FHA monthly mortgage payments at a time when the rest of the market is trending costlier because of rising interest rates. Consider this scenario prepared for this column by Michael Zimmerman, senior vice president of MGIC, a major private mortgage insurer based in Milwaukee.

Say you want to buy a house and find one for $220,000, which is slightly below the median national price of existing homes at the end of last year. You’ve got a 720 FICO credit score and can make a 5 percent down payment, resulting in a loan amount of $209,000. Before the cut in FHA fees, at typical interest rates quoted earlier this month, you’d have paid $1,153 monthly (exclusive of property taxes and hazard insurance) for an FHA-insured mortgage. The same loan but with private mortgage insurance would have cost $2 more a month – $1,155. On monthly payments, your FHA loan and a conventional Fannie/Freddie alternative would have cost about the same.

After the premium reduction, however, the monthly cost for the FHA loan will be $45 cheaper than the competing conventional loan – a cost advantage of $540 the first year. For larger sized loans, the savings will be greater. No big deal? It depends- For new home buyers short of cash, any savings can be important. Plus at the application stage, the lower mortgage cost helps buyers’ debt-to income (DTI) ratio calculations – a crucial factor in loan approvals and rejections.

What about first-timers who can’t come up with any more than the absolute minimal down payment allowed on either FHA (3.5 percent) or Fannie/Freddie conventional mortgages (3 percent)? Here the cost differentials become significantly greater. Purchasing the same $220,000 house with a 720 FICO score and a 3.5 percent down payment FHA loan will cost you $129 less per month following the premium reduction compared with a 3 percent down conventional loan eligible for sale to Fannie Mae or Freddie Mac, according to an analysis prepared by Paul Skeens, president of Colonial Mortgage Group, a lender based in Waldorf, Maryland. The FHA payment comes to $1,088.45, the conventional loan payment to $1,217.45.

You might say, wow, it looks like for new low down payment buyers, FHA is always the way to go. But that’s not the case. Keep these pros and cons in mind when you comparison shop for a mortgage requiring minimal dollars down-

- Both FHA and conventional loans require payment of mortgage insurance premiums. But FHA loans come with a glaring negative- Unlike private mortgage insurance, FHA premiums are non-cancellable for the life of the loan if you make less than a 10 percent down payment. With a conventional loan, you get to cancel your premium payments when you achieve a 20 percent equity stake in the house. That can occur when your principal payments reduce your debt to 80 percent of the original balance or an increase in the market value of your house grows your equity. When your loan balance declines to 78 percent – your equity is 22 percent – your loan servicer is required by federal law to terminate premium payments.

- On the plus side, FHA has far more generous and forgiving underwriting rules on credit, debt-to-income ratios and financial assistance from home sellers to help with buyers’ closing costs. It exists to serve working families and individuals who might otherwise find it difficult to get an affordable loan. If your FICO credit score is below 720 and you can cobble together a 3.5 percent down payment, FHA is usually the right choice. The new, lower premiums merely underline that fact.