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Low capital gains tax rates may have you, like many investors, rethinking your investment strategies, particularly if you own real estate. Depending on your goals and circumstances, this may be a good opportunity for you to exit the real estate market gracefully - and relatively inexpensively.
Although like-kind exchanges are particularly advantageous because you can defer tax, they've lost some of their appeal because capital gains tax rates are lower than they've been in years.
REVIEW THE RATES
The 2003 tax act reduced the 20% and 10% long-term capital gains tax rates to 15% and 5%, respectively. (The 5% rate will drop to zero in 2008.) Unless Congress makes the tax cut permanent, both rates will return to their previous levels in 2009. The act also suspended, until 2009, the 18% capital gains tax rate for certain assets held more than five years (8% for lower-income taxpayers).
But the tax law made no changes to the treatment of recaptured depreciation. Real estate gains attributable to previous depreciation deductions are still taxed at either a maximum rate of 25% or your top tax bracket.
In light of the current tax law, investors should re-examine tax-deferral strategies, such as like-kind exchanges. Although they are a valuable tool, the current lower capital gains tax rates diminish the benefits of tax deferral.
LEARN THE RULES
Usually, when you sell or exchange property, you must recognize a gain or loss. But you may be able to defer the tax by exchanging real estate for other "like-kind" property. Both must be: 1) located in the United States, and 2) used in a trade or business or held for investment.
For example, you could carry over the tax basis from an apartment building in New York City to a shopping center in Montana. And you can defer tax on the original gain from the relinquished property until you sell the replacement property. Keep in mind that some states will tax you on this transaction.
You may be able to eliminate capital gains taxes if the property is in your estate at your death when the estate tax is in effect. The beneficiary will receive an unlimited step-up in basis. If he or she sells the property immediately, no capital gains tax will be due because his or her basis will equal the selling price (assuming no discounts were taken in the valuation of the property).
Additional rules apply to partially tax-free and mortgaged property exchanges. You must trade up in fair market value and equity or gain is recognized.
CONSIDER THE IMPACT
Evaluating a like-kind exchange used to be more straightforward. When capital gains rates were higher, deferring tax was typically a wise strategy - under the theory that a dollar today is worth more than a dollar tomorrow. But now that the rates are lower, the benefits of tax deferral may be outweighed by the costs. There are more factors to consider, such as:
Alternative investments. Other investments, such as stock, may be more attractive because the tax rate on qualified dividends is only 15%. Evaluate whether higher potential returns on other investments are more advantageous than deferring capital gains taxes on real estate.
Future depreciation. When the tax basis of the relinquished property becomes the tax basis of the replacement property in a like-kind exchange, it usually results in lower depreciation deductions than would be available if you purchased the replacement property.
Unused capital losses. If you can use capital losses from prior years to offset current capital gains, now may be a good time to sell. (Please note that it may be better to match short-term capital losses with short-term capital gains.) You can reduce or even eliminate capital gains taxes and reinvest in property with a higher tax basis. This would minimize future gains if you sell the property when capital gains rates are higher.
Recaptured depreciation. Carefully analyze the amount of gain attributable to prior depreciation because it can greatly affect your cost-benefit analysis. Recaptured depreciation is taxed at 25%, while gain in excess of depreciation is taxed at 15%. But certain depreciation may be recaptured at ordinary rates.
WEIGH YOUR OPTIONS
Like many investors, you've probably changed your financial strategy to benefit from the 2003 tax law changes. But you may not have re-evaluated your real estate strategies. Now is a good time to do so because capital gains tax rates are low. Although the tax impact is an important factor in any decision, you should consider additional elements including costs and other financial advantages. Before deciding, weigh your options and speak with an accountant in our firm.
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