Throughout much of the 20th century, capital gains have been taxed at a lower rate than other income or were only partially exposed to taxation. This lower rate was justified because it encouraged capital formation and investment, fostered risk-taking and helped to offset the effect of inflation on capital gains. History has shown that the tax rate applied to capital gains and dividends has a substantial impact on the way taxpayers handle income from capital.
Even before the last Presidential election, commercial real estate investors were making statements that when they sold their property they wanted to “cash out” because “if Obama gets elected he will raise the capital gains tax to 20% or much more”. Many of these investors have been living up to their word and cashing out of the properties (and condoned by some of their advisors). Now quite frankly, before the election I was calling this the “McCain/Obama effect” because no matter who would have been elected to the office of President, part of their agenda would be to increase the capital gains tax.
Since the election and the subsequent passage of the TARP and TALF and other huge scheduled spending bills have given birth to a second concern among investors and their advisors: hyper-inflation. Let’s dissect these issues on an individual basis and then re-assemble them into a solution for concerned investors and advisors.
Although capital gain tax rates are set to be increased to 20% in 2011, many taxpayers are uncertain as to what rates might be in the future due to what they are hearing from the White House and congress. Let’s compare what happens to the taxpayer who sells today at the current 15% maximum rate versus the same taxpayer electing to defer all capital gain taxes via a §1031 tax deferred exchange and selling at a presumed higher capital gain tax rate of 20% in the future. Assume the following: A taxpayer is selling an investment property for $1,200,000 with $300,000 remaining debt and $820,000 net equity (after cost of sale of $80,000, but before taxes); the taxpayer’s adjusted basis is $400,000 and their gain is $720,000, of which $37,500 is the capital gains tax on depreciation (the 25% tax was signed into law by President Clinton in 1997) and $570,000 (taxed at 15%) is the remaining capital gain; the state tax rate (example-each state is different) is 6% on the entire capital gain of $720,000. This nets to total taxes of $166,200 leaving, net equity after tax, of $653,000. Assume the after-tax sale proceeds are reinvested into another investment property with a 25% down payment (75% LTV), the taxpayer would be able to acquire a property valued at $2,615,200. However, by utilizing a §1031 Tax Deferred Exchange the taxpayer would be able to use the entire gross equity of $820,000 and acquire a property valued at $3,280,000. The incremental value of property acquired would be $664,800.
CALCULATE NET ADJUSTED BASIS
Original Purchase Price (Basis) $500,000
plus Capital Improvement +$50,000
Less Depreciation -$150,000
equals Net Adjusted Basis $400,000
CALCULATE CAPITAL GAIN*
Sales Price $1,200,000
Less Adjusted Basis -$400,000
Less Cost of Sale -$80,000
equals CAPITAL GAIN $720,000
CALCULATE CAPITAL GAIN TAX DUE
Recaptured Depreciation (25% x $150,000) $37,500
plus Federal Capital Gain (15%x$570,000) +$85,500
plus State Tax (GA 6.0%x $720,000) +$43,200
TOTAL TAX DUE $166,200
The elimination of the Alternative Minimum Tax exemption and the creation of Capital Gains Tax Preference items that could create even more taxes are not addressed in this scenario, however, AMT implications need to be considered.
CALCULATE AFTER-TAX EQUITY
Sales Price $1,200,000
Less Cost of Sale -$80,000
Less Loan Balances -$300,000
equals GROSS EQUITY $820,000
Less Capital Gain Taxes Due $166,200
Equals AFTER-TAX EQUITY $653,800
ANALYZE REINVESTMENT - SALE
After-Tax Equity x 4 $2,615,200
ANALYZE REINVESTMENT – EXCHANGE
Gross Equity = Net Equity $820,000
Gross Equity x 4 $3,280,000
Albert Einstein was once asked what he felt was the most powerful force in the world and his answer was “The Theory of compounding Interest”:
Let’s assume that the taxpayer is 35, 40, 50 years old or older and doesn’t need the cash until retirement and replacement investment property appreciates at only 6% per year.
Theory of Compounded Interest:
Utilizing the original $166,200 Tax Deferral Money exponentially creates wealth (e.g. 6% per Year) appreciation of original leveraged amount of $664,800 to over $1,300,000 in 12 Years. Even if the capital gains tax rates (depreciation, capital gains and state blended rises to 40%, the investor is still well ahead of the game.
Also, there is no limit to the number of exchanges a taxpayer can effect , therefore if the taxpayer decides that a replacement property has peaked in value and effects other §1031 exchanges to leverage their additional gains/equity and deferred capital gains taxes into other opportunistic replacement properties.
Hyperinflation:
If our national spending habits do create an inflationary economy; what is one of the best hedge assets to have in one’s portfolio? Commercial Real Estate: and if we see inflation rates skyrocket to 20% or more, the exchanger’s $166,200 tax deferral that leveraged the additional value of $664,800 would double that value in a lot less time than 12 years.
Conclusion:
Investors and their advisors should examine all factors regarding the individual investor's financial goals and tax situations and before they make hasty uninformed decisions.
Copyright William B. Hood, 2009
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