The Budget, Capital Gains and Politics

A couple weeks back, the Obama Administration submitted its fiscal year 2011 budget outlining the government's plans for tax change. But reports indicate that the timetable for tax hikes may delayed. Some Democratic Congress members are worried that going along with the Obama Administration's increases might cause their re-election bids to fail. So how might this affect capital gains tax in 2010 and beyond?

For joint filers making more than $250,000 (some report this number around $231,000)and single filers making more than $200,000 (including the amount of the gain, keep in mind), Obama has proposed increasing the tax rate to 20% for long-term capital gains (and qualified dividends). The current rate of 15% would be extended for those making less than these amounts.

Nine years later, most have embraced and accepted the policy to tax capital gains and qualified dividend at the same special rate. However, because of this generally accepted principle, there is the possibility that long term capital gains rates may go higher than Obama's 20% proposal. The justification lies in the qualified dividend half of the "same treatment" proposal. If dividends were treated as ordinary income, rates could go as high as 36%. Congress may decide, under the recently enacted Pay-Go rules, that deficit issues and budget scoring require a higher rate. Some have indicated a "blended" same treatement rate of 25% or 28% is a very real possibility.

There is also the potential that November elections will concern enough Congress members to simply extend the Bush tax cuts for another year. Avoiding any action this year would mean the Bush capital gains tax cut would expire at the end of 2010. Many argue (or perhaps justify their lack of action - depending on your political perspective) that now is not the time to raise capital gain tax rates. With the economy in a fragile state of perceived tepid recovery, they should wait to take any action that would raise taxes.

So how do the proposed increases impact your decision to sell investment property? Some time back, we posted a blog about how this tax change may impact your decision to defer the gain through a 1031 exchange. Most would think that paying 15% now sounds a whole lot better than paying 20%, or worse, 25% or 28% some time down the road. But even with tax rates increasing, in many cases, it still may make sense to defer the gain (versus paying 15% tax that is gone today). The answer depends on the marginal increase in taxes, the amount of time you aniticipate holding the asset and your expected cash-on-cash expected rate of return over that period. If you earn a rate of return, and anticipate holding the replacement asset for a length of time, the answer may surprise you. The time value of holding on to that tax money can be powerful!

Discussing your individual situation with your tax advisor is recommended. Of course, you can and/or your tax professional can always contact 1031 Corporation Exchange Professionals for free consultation of your like-kind exchange questions. Even the call is free 888-367-1031.

Year-end Tax Planning with Section 1031

If you are selling property before the end of the calendar year, you have a potential opportunity to plan for taxes in 2010 by utilizing Internal Revenue Code section 1031 as a tool. Whether a 1031 exchange is ultimately completed or not, there may be an opportunity to choose whether the tax will be paid in 2009 or 2010. This is because, under exchange rules, your right to receive the proceeds from the sale of the property are held by a third party Qualified Intermediary. If you are unable to identify or close on a sale, and subsequently, the exchange fails, your first right to the proceeds doesn't occur until 2010. How is that? It has to do with the time of year we have entered.

Under 1031 exchange rules, a person exchanging property may receive the sale proceeds (a) after the expiration of the 45 day identification period (if the taxpayer did not identify any replacement property); or, (b) the date upon which the taxpayer acquires all replacement property identified by the taxpayer in the exchange, or (c) at the end of the 180 day exchange period. So if you sell a property on December 15th, your 45 day period would not occur until January 29th.

Section 1031 says that if your exchange fails in a different tax year than the year you sold it, the IRS's installment sale rules kick in. So, the taxes that would be due in 2009 could be deferred until 2010. I say COULD be because the installment sale rules also allow you to elect out of them.

If the Obama administration and Congress decide to raise capital gains rates before the Bush tax cut is set to expire at the end of 2010, a taxpayer whose exchange failed could elect out of the installment reporting rules. This also might help if you determine, before filing your tax return, that it would be better to go ahead and recognize the gain in 2009. This stategy, setting up an exchange now, would allow you to plan and recognize the gain in the year of greater tax benefit for you.

Of course, you should have a legitimate intent to complete an exchange and not simply look at this as a tax deferral strategy. However, if you are selling real estate and MIGHT reinvest the proceeds in replacement property, it could certainly make sense to setting up an exchange - just in case. If you are considering this option, you should also consult with your tax accountant or attorney regarding your specific tax situation. For more information on this option, visit our 1031 exchange professionals website or give us a call at 888-367-1031.

The Compounding Effect

The following post is a portion of an article written by Ronald Raitz and appearing in the Sept/Oct edition of Commercial Investment Real Estate, The official magazine of the CCIM.

When Albert Einstein was asked, “What is the most powerful force in the universe?” His reply was, “Compound interest.” People in the financial services industry understand the effects of compounding: For example, whether an investor starts funding an individual retirement account at age 20 or 40 results in a dramatically different retirement balance at age 59½. The simplest of illustrations — the “double the penny” example — further highlights the sometimes surprising benefits of compounding: A penny doubled every day for a month is worth only two cents on day two, but on day 31 it is worth $64 million. Compounding plus time can indeed produce impressive investment growth.

Potentially the most powerful benefit of a 1031 exchange, the compounding effect also is the most overlooked. The key to getting the highest compounding result is keeping all of the money working for the investor — not only now but also into the future. In an exchange, the amount of tax that otherwise would be paid is reinvested. The projected future value of the compounded yield on the deferred tax becomes very substantial over time.

Many real estate investors also add leverage, which significantly amplifies the compounding effect. For example, in 1988, an investor who possessed strong management skills sold a $1 million property that had a $200,000 basis. Without utilizing an exchange, the gain on the sale would have been $800,000 with approximately $200,000 in taxes due. After paying the taxes, there would have been approximately $800,000 after-tax cash to reinvest.

But the investor exchanged the property and bought a $1 million income-producing replacement property that was 85 percent occupied. He put $200,000 down — exactly the same amount he otherwise would not have had without the exchange. Two years later, after making necessary management adjustments, he increased the property’s occupancy to 94 percent and sold it for $1.4 million. The $200,000 that he put down on the property (money that would have been used to pay the recognized gain in 1988) added to the $400,000 he just made equals $600,000.

The investor did another exchange and put the $600,000 in proceeds down on a $2 million income property that had been under-managed and was at 83 percent occupancy. Three years later, after achieving 92 percent occupancy in the property, the investor sold it for $2.6 million. With the $600,000 he had put down plus the $600,000 he made on the sale, after only five years the $200,000 tax that was deferred had grown to $1.2 million. Alternatively, without the exchange strategy the investor would have had no compounding benefit from his investments because the initial $200,000 would have been paid to cover the tax obligation.

Compounding combined with leverage can build wealth very quickly. Over a 12-year period, this investor did five exchanges and turned the money that he otherwise would not have had ($200,000) into $4.8 million.

Many investors have developed exchange strategies that have enabled them to go from a modest net worth to a very high net worth in a 10- to 20-year time frame. Clearly, these real-life examples are achieved more easily when real estate is in an up cycle, but this does not negate the potential benefits of employing a 1031 exchange strategy and holding real estate through the down cycles. Over time, the investors still come out far ahead of where they otherwise would have been if they had sold, paid the tax, and gone into an alternative investment.

Since there are no restrictions on the number of exchanges a taxpayer can complete, this strategy can be used during the taxpayer’s entire lifetime. Although some investors eventually sell property that is acquired via an exchange and pay the tax, it is very common to never cash out and carry investments into the taxpayer’s estate. At that point, the estate receives a stepped-up basis and the tax consequence disappears.

Possible capital gains tax increase on the horizon?

Recently, the Wall Street Journal released an article discussing a recent phenomena we've seen in the exchange business. The article, written by Dale Arden is titled Property Investors Fear Gains-Tax Rise, Shift 1031 Strategy. It discussed the idea that real estate investors are not using 1031 exchanges as a strategy in light of the possibility that a new administration will raise capital gains tax rates. Instead, they are taking advantage of, what is perceived as the lowest capital gains tax rate, the 15% long-term capital gains tax.

We discussed this a couple months back in an entry titled, AMT, Capital Gains and the Time Value of Money. The answer to the question really comes down to whether it is financially better to pay a 15% tax rate or pay a 20% or 25% rate when the property is sold some years out. Central to the analysis of this is the assumptions made. When will the replacement property be sold and at what level of appreciation? The longer the hold period and the greater the appreciation, the more likelihood that it may still make sense to defer the gain and pay the tax later. That, of course, assumes there is a capital gains tax that is higher at the date you defer than today. After all, they could go up only to be reduced at some later date before you eventually cash out and pay the tax. Betting on politics...now that is a tricky game!

Gloomy housing market forecasts aren't all bad

You could spend a significant amount of your time each day reading various economic forecasts. It seems that everyone has an opinion. While many of them say that we are headed for - or perhaps already in the midst of - a recession, the reasons for it, the severity of the decline and the length of time until a recovery is seen are items of major debate.

In looking at various economic forecasts, I am naturally drawn to those that deal with real estate markets. Having a vested interest in the health of real estate and realizing that the state of the housing market is such a signficant factor in the economy, I am looking for prognostications that talk specifically about this area.

While the increasing number of personal bankruptcies, a growing concern with foreclosure levels and the subprime lending credit crunch have consistently been in the news, a number of other concerns still exist that have many wondering how long it will take for housing to recover.

I recently read a report from Professor Robert Shiller of Yale University that had some very interesting ideas. He believes that, over the past decade, two million excess homes have been built. The combination of low interest rates, rising real estate prices and weak lending guidelines has resulted in irrational speculation in housing product. This in turn has led to builders increasing the product on the market and repeated cycles of overbuilding. The fallout resulting from this glut of real estate is a loss of one trillion dollars in the housing market. Professor Shiller believes that we could still see a loss as much as three times that amount before we hit bottom. What does his forecast mean in terms of percentages? An expectated 20% to 25% further decline in home prices.

There are reports that supported Prof. Shiller's expectation. Comparative, statistical evidence indicates a 24% drop in home prices is required to bring housing prices back in line with building costs, a 27% decline to bring home prices back in balance with rents. Of course, you could argue that building costs or rents are artificially low and could increase to balance some of this necessary balancing decline in real estate prices out. However, current real estate prices are still estimated to be 50% higher than the historical average price per square foot when adjusted for inflation.

Many are calling the headline bad news for '08 to be the counterparty risk in the credit default swap market - similar in scope to the story that subprime was in 2007. Some believe that continuing losses at banks will force the need to raise capital. This further instability in the credit markets will cause further tightening of lending standards - traditionally the blamed culprit. Forecasts call for the next twelve to eighteen months of significant declines in credit availability. Since credit availability is key to real estate market recovery, many see this as concern that the economy will be slower than expected in its recovery.

So where is the silver lining in an economy of tough real estate markets, uncertain political climate, increasing oil prices and a decreasing stock market? Tough times bring about significant opportunity. Many investors were extremely savvy with their investments of RTC-owned property in the early 1990's. I know many stories of investors buying something on the cheap when no one else was buying and looking like a genuis a few years later. These opportunities tend to resurface when times are difficult. It is the smart investor that remains calm and looks for opportunities among the bad news.

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.