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‘Arcane tax law' in state could be on the way out

What has been described as an “arcane tax law” that has prevented Mississippi from getting much in the way of investments from out of state for Section 1031 real estate exchanges could be on its way out.

The Mississippi House of Representatives has unanimously passed a tax law change that will put Mississippi in line with federal government guidelines regarding Sections 1031 and 1033 of the Internal Revenue Code. This new tax law focuses on the tax-deferred treatment of capital gains for investment real estate exchanged in or out of the state, and is now under consideration in the Mississippi Senate.

“While property owners in 47 other states can swap appreciated real estate and defer capital gains regardless of where they reinvest, Mississippi property owners are forced to pay state capital gains taxes on any proceeds they swap out of state,” said David Comstock, a financial planner with Comstock Financial Services, Gulfport. “The current law is discouraging investment in Mississippi.”

Roots to roadblock?

Comstock said back when real estate investing was still a local affair, the decision to ignore federal tax guidelines was believed to help keep the state’s property owners and their real estate roots in Mississippi. He believes that it presently serves as a formidable roadblock for hundreds of millions of dollars seeking to invest in the state’s real estate and economic future.

“Last year, large tax-conscious investors such as REITs (real estate investment trust), pension plans, endowments and trusts, along with many individual property owners, exchanged more than $250 billion of appreciated real estate across this country tax-deferred,” Comstock said. “Unfortunately, almost every penny of these Section 1031 real estate investments and the resulting economic development continues to steer clear of Mississippi and our arcane tax ‘penalty’ on real estate exchanges out of state.”

Out-of-state investors are leery of investing in Mississippi, because if they decided to later exchange out of the state, they would have to pay the 5% capital gains tax.

“The current law is discouraging investment in Mississippi,” Comstock said. “A lot of properties out there now are sold as a security for investors who want to do a passive investment. They no longer want to actively manage real estate. Mississippi punishes them because they have to pay capital gains taxes if they leave the state with their investment money. Therefore, investors from another state would not want to 1031 exchange into Mississippi because of the same situation if they choose to leave. There are few, if any, outside investors in the 1031 exchange world that would entertain coming to Mississippi for that reason.”

Boosting post-Katrina opportunities

Besides Mississippi, only Pennsylvania and Vermont don’t follow the federal guidelines. Comstock thinks bringing Mississippi in line with federal guidelines would be particularly helpful to investment real estate owners whose property was destroyed by Hurricane Katrina. This would allow more opportunities for investors to do a 1033 exchange with their insurance monies and defer the state capital gains tax.

“A lot of them are going to have to find other investments outside of the state,” he said. “Before, if they went outside of the state, they would be subject to paying state capital gains tax. There are some huge advantages to people who do a 1031 or 1033 exchange sold as a security. This is a great help for accredited investors who want to go from actively managed property to passively managed property.”

Comstock said if the bill is approved by the Legislature, some sponsors of 1031 exchange properties will now take a look at Mississippi who wouldn’t do so before.

“Major 1031 sponsors are now looking at the Coast for investment possibilities who, before, had no interest in coming here even with the GO Zone advantages offered,” Comstock said. “This new position is based on the possibility of Mississippi now following federal guidelines. Investors, who were holding onto investment property in the state until death, will now be able to exchange it tax deferred. This opens the property to new investors who could create jobs and opportunities for others.”

Under current tax law, there are no capital gains passed onto heirs when the property owner passes away.

Encouraging development

Rep. Warner McBride of Batesville, the author of House Bill 1585 that passed 188 to zero, said he saw the legislation as a major way to encourage development of the state.

“Some people think it could have major implications,” McBride said. “The current law may be discouraging in Mississippi because they have to pay a 5% tax on reinvestment that they wouldn’t have to pay under the changed law. We would now conform with the federal laws and be in line with the 47 states who already do it.”

McBride said the legislation currently being considered by the Senate Finance Committee could have an impact all over the state, but especially on the Gulf Coast with the rebuilding efforts. For example, if someone had property on the Coast and wanted to sell out for a large condominium development, they could take advantage of a 1031 real estate exchange without having a large tax payment due.

“It is not just for rich people,” McBride said. “It would help many Mississippians who might have a piece of property they want to sell but don’t because of tax consequences. This would help alleviate some of the tax consequences. Sometimes communities can’t rebuild certain areas because a piece of property needs to be improved. But for the owners, it might not be a good idea financially to sell it. Perhaps this would give them an incentive to divest of the property without being penalized in such a detrimental manner.”

Into the market

Sen. Gray Tollison of Oxford, who supports the law change, said the Senate has until March 13 to consider the House bill. The law was brought to Tollison’s attention at a Tupelo chamber of commerce meeting attended by people involved in the property swaps.

“You have real estate investment trusts that are dealing with packaging properties, and I think that is not only REITs, but other types of trust and pension plans,” Tollison said. “So removing that 5% tax would kind of put Mississippi in the market in terms of being an investment opportunity. I think the Coast, especially, and all the areas of the GO Zone would benefit from this. Any downside on revenues, losing 5%, would be made up by the investments made that would create other sources of revenues.”

Tollison said right now Mississippi is not even a player in this big investment market. Some big real estate firms won’t even consider the state.

“When you are talking about millions of dollars, 5% is a lot of money,” he said. “When you have 47 other states that don’t charge 5%, they are just going to continue working in those states.”

Tollison said he believes passage of the law would bring an infusion of investment to Mississippi that might not otherwise happen. He sees that as a positive.

The proposed legislation has not been opposed by the Mississippi State Tax Commission, which stated that “this is a public policy decision for the Legislature; the State Tax Commission will implement the provisions of HB 1585 if it should become law.”

Contact MBJ contributing writer Becky Gillette at bgillette@bellsouth.net.

About Becky Gillette

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