Alternative Minimum Tax, Capital Gains and the Time Value of Money

There are rumors floating around out in cyberspace that Congress will take a hard look at creating a more permanent fix for the Alternative Minimum Tax. More than a few are suggesting the possibility of increasing the capital gains tax rate back to 20% to offset the AMT fix. We've seen talk of these rumors recently begin to kept many from completing exchanges. I've actually heard people say it is better to pay 15% now versus the potential to pay a 20% capital tax rate at some later date. (Most of the time this statement comes right after the other assumed imminence of "when the Democrats take power back".) For that reason alone, some are deciding to NOT complete a 1031 exchange.

While that thinking seems to save 5% in taxes, it also ignores the fact that time and inflation affects the value of money. The time value of the 15% tax money paid today versus the eventual higher (presumed) 20% taxable sale may or may not save the taxpayer. It depends on when that transaction might occur. Follow me?

Consider a scenario where the 15% long-term tax paid would instead be reinvested (we'll even ignore the additional state tax paid). In other words, rather than paying Uncle Sam today, the money is reinvested, via a 1031 exchange, into investment property. Let's assume that this taxpayer is planning on reinvesting the funds and planning to hold the replacement property for ten years. At that time, the taxpayer plans on selling the property and paying the taxes (ten years from now). We'll also assume the reinvested money will conservatively earn a inflation-free rate of 4% a year. In other words, if inflation runs 3%, the investment will earn 7%. (Just to make the analysis even more conservative, we'll even ignore the ability to leverage that tax-free, reinvested money into an even larger investment).

So what is the present value of that 15% in taxes paid ten years from now? To figure this out, let's illustrate what the two scenarios have. If you pay the tax on a $100 capital gain today, you get $85, right? But if you take the $100 and reinvest it for 10 years and earn 4%, after inflation, each year, you'll have $149 in today's dollars (you'll actually have much more if you assume some inflation). So, you then turn around and pay 20% capital gains tax on $149 - winding up with $119 - versus the $85 you'd have today if you paid the lower tax today.

So why again, if you are planning on reinvesting the funds anyway, would you pay the 15% today versus the 20% ten years from now? And let's not mention there is typically a state capital gains tax or talk about the uncertainty that five or ten years from now, the capital gains tax rate will not be, again, changed/reduced.