The Capital Gains Tax (long) - Posted by Paul_NY

Posted by Paul_NY on February 15, 2000 at 20:34:31:

Thought this might be of interest to some of you:

The Capital Gains Tax - What it Means for Real Estate Investors, by Frank Gallinelli

Some History

It has been more than a decade since Congress passed the Tax Reform Act of 1986. Prior to Tax Reform, taxpayers could exclude 50% of long-term capital gains from their income. Starting in 1987, however, capital gains were taxed at the same rate as ordinary income. In other words, there was no longer any meaningful tax benefit associated with the risky business of investing capital to develop office buildings, retail space or multi-family housing.

Perhaps it was only a coincidence, but the real estate industry ? commercial real estate in particular ? suffered a downturn that was worse that any in the post-war era. At the same time, we had a stock market crash and, in many parts of the country, the worst recession in decades. Not much reason for investor confidence.

From time to time, one political leader or another called for restoration of some sort of capital gains tax relief, but nothing came to pass. In the early 90s, a new bill made the maximum tax on net capital gains 28%, but that was the only break until the Taxpayer Relief Act of 1997.

The debate ? and the changes ? concerning capital gains ran quite literally until the final reconciliation of the House and Senate versions. What resulted is hard to describe, although that is exactly what we will try to do here. If it were computer program code instead of law, it would be called “spaghetti.”

The New Rules

The sound-bite explanation of the law is that the tax on capital gains has been reduced from 28% to 20%. That?s true, sort of and sometimes, and as long as we are not talking about investment real estate.

Actually, there is one set of rules for taxpayers in the 15% bracket and another for taxpayers at 28% or higher. Both groups pay tax on capital gains at ordinary income rates if they hold their property 12 months or less. They both pay at ordinary rates but at a maximum of 28% if they hold their property more than 12 months but not more than 18.

If the sale occurs after 18 months, the gain is considered long-term. Previously, the holding period was 12 months. The 15% taxpayer pays a maximum of 10% on a long-term gain, or if he or she has held the property for more than 5 years, a maximum of 8%.

After 18 months, the taxpayer in the 28% or greater bracket pays a maximum of 20% on a long-term gain, unless he or she acquired the property after the year 2000 and also held it for more than 5 years, in which case the maximum tax would be 18%.

Sales that occurred after May 6, 1997 but before July 29, 1997, where the property was held more than 12 months, are also treated as long-term capital gains and qualify for the 20% or 10% maximums.

Apparently concerned that this might all be too simple, Congress also made a special rule for real estate (not principal residence) only: That portion of a long-term capital gain attributable to prior deductions for depreciation would be taxed at a rate of not more than 25%, with the balance taxed at whichever of the other four rates (i.e., 8%, 10%, 18% or 20%) applied.

The rules concerning capital losses were unchanged in 1997. Capital losses may be deducted up to the extent of capital gains; in addition, up to $3,000 of capital losses may be deducted against ordinary income. Unused capital losses can still be carried forward.

What It Means

Got that? What does it really mean?

If you are a 28% or higher taxpayer, you will pay an effective capital gains rate somewhere between 20% and 25%. You will also have to wait a little longer ? 18 months instead of 12 ? before you can achieve this lower rate. At some point in the future (2006, provided the rules aren?t changed again), that 20% could be 18%.

Your effective rate is a blend of 25% on the part of the gain attributable to prior depreciation deductions, and 20% on the balance of the gain. There is an interesting subtext here. If you are now selling a property that you held through the commercial real estate decline (i.e., if you are a resourceful survivor who did not exacerbate the situation by handing your property back to the bank), then the market value of that property may now be approaching what you originally paid for it. If that is the case, then your capital gain will be attributable mostly to prior depreciation (and taxed at the higher 25% rate) rather than to the economic gain which you expected but never saw. In other words, you get to pay twice for a bad economy. You?re welcome.

There is another curious sidebar to the new law. During the decade since the Tax Reform Act, some politicians and activists reached near-operatic heights in declaring that capital gains relief benefits only the wealthiest of taxpayers. Apparently the tens of millions of Americans who risk part of their savings in small stock portfolios, mutual funds, multi-family real estate and the like were below the threshold of their attention. After years of debate and reams of proposals and counter-proposals, we note that it is the highest-bracket taxpayer (39.6%) that has returned to a capital gains rate almost exactly equal to what it was before Tax Reform.

The new capital gains law is certainly not generous to the real estate investor, and it is far more complex than it needs to be. But, if you are like many of the investors we talk to, you had probably adjusted your expectations long ago. We got something, and to coin a cliché, something is better than nothing.

by Frank Gallinelli - © 1997-1999, RealData®, Inc. All Rights Reserved