Investors may be uncomfortable with real-estate values and may think now is the time to sellInvestors may be uncomfortable with real-estate values and may think now is the time to sell
BY DOUG FRENCH

 As bad as the residential market has been for real estate investors, commercial property values are on fire. How come? In my view, what drives the commercial real estate market is the ability for real-estate investors to delay - in some cases forever - paying capital gains taxes by using 1031 exchanges. 

Imagine if stock-market investors back in 2000 could have realized their gains by selling, but then could have rolled the proceeds tax free into like kind stocks. Would that have tempered the crash? You bet it would have. 

Gary North wrote in an article entitled, "When the Yield Curve Flips" on LewRockwell.com: "Stock market bulls will, as always, resist any bearish analysis, just as they have resisted since February and March of 2000, when I issued my pair of warnings that the price/earnings ratio indicated a looming fall in prices. My conclusion, based on Federal Reserve policy, was just too painful to bear. It involved selling assets, which requires a payment of capital gain taxes. Asset owners with a paper profit like to pretend that they can defer the payment of capital gains taxes until their death. In other words, they are lifetime perma-bulls."

But the tax code that allows 1031 exchanges doesn't include stocks or bonds, but instead investment real estate. Thus, investors who have made large gains on their investment real estate, may be uncomfortable with real-estate values and may think now is the time to sell. These investors may even intend to cash out of their properties and invest the money in bonds or stocks or gold. 

But, then they go talk to their accountants. Their accountants will remind the investors not only of how large the capital gain (and the tax bill) is on the property sales, but also of how much more in taxes they owe on the recapture of the depreciation they took all of those years. 

Most people don't want to pay the government a whole bunch of money when they sell their properties. Even if they think real estate is over valued they'd rather buy overvalued real estate than hand the government money that will be lost forever. Even if you pay too much for real estate, it has a chance of increasing in value over time. You have no chance of getting any money back that the government takes. So 1031 exchanges are a way for investors to keep all of their money invested, rather than have the government take a portion.

These 1031 exchanges allow real-estate investors to: trade up to larger investment properties, relocate real estate investments, change the type of real estate investments they have, diversify into multiple properties, and trade real estate that doesn't produce cash flow into properties that do produce cash flow. 

This tax law gives investment real estate a huge advantage over other investment vehicles. It is no wonder the commercial real estate market continues to be strong. Furthermore, 1031 exchanges require that you exchange for a property of equal or greater value and if you have debt on the property you are selling you must have debt of an equal or greater amount on the property you exchange for. So, essentially to take full advantage of the tax deferment allowed by 1031 exchanges, a person can't wind down their real estate investments over time. 

Also, investors must buy their real estate quickly, essentially within six months. Thus, real-estate buyers constantly have a sense of urgency. They can't wait around for a "market correction" or a better "buying opportunity." They must identify their replacement property right away and execute the purchase. 

And now the rules have been made even easier for 1031 investors. A person can now swap out of his individually owned small investment property into large properties as a tenant-in-common (TIC) with other small investors. In 2002, the IRS clarified the rules, allowing TIC investment. TICs are perfect for investors who are tired of collecting rent and other property management chores. 

Because of the 1031 tax code, commercial property values will likely remain strong as long as interest rates stay tame. But beware - any talk of disallowing these tax-free exchanges would devastate the real-estate market and the banks that lend on real estate, making the S & L cleanup look small. LW

Doug French, associate editor of Liberty Watch: The Magazine, is an executive vice president of a Nevada bank. He is the 2005 recipient of the Murray N. Rothbard Award from the Center for Libertarian Studies.