The 2003 Capital Gain Tax Reduction:
"What It Means for Real Estate Investors"

On May 28, 2003 the President approved a $350 bil-lion tax cut that includes reductions in dividend and capital gain taxes. Long-term capital gain tax rates for investors in the top tax brackets are reduced to 15 per-cent from 20 percent. The rates are reduced to 5 per-cent for investors in the 10 percent and 15 percent brackets. The changes are retroactive to May 6, 2003.

Even with the lower capital gain rates, real estate in-vestors should first determine their total tax liability before selling real estate. Often the impact of depre-ciation recapture at 25 percent, plus the combined federal and state tax owed result in a §1031 tax de-ferred exchange being a much better alternative. In fact, when analyzing the purchasing power of an ex-change as compared to a sale, the value of tax deferral becomes even more dramatic.

EXAMPLE: Assume an investment property owner sells a rental property for $700,000. The owner originally purchased the property for $200,000. There is $100,000 of debt and the property has been fully de-preciated (assuming 80% of the property is deprecia-ble). The investor has $500,000 of capital gain plus $160,000 of depreciation recapture. They are in the top federal tax bracket and their state tax rate is 5%.

Depreciation Recapture: $160,000 (depreciation recapture) x 25% = $40,000

Plus: Federal Capital Gain Tax: $500,000 (capital gain balance) x 15% = $75,000

Plus: State Taxes:
$660,000 x 5% = $33,000

Equals: Total Taxes Owed in a Sale: = $148,000

BENEFIT OF IRC §1031: The major benefit of an ex-change is not the actual savings but the purchasing power provided by this tax savings! The example below analyzes the value of a new property that could be ac-quired in an exchange versus a sale. The comparison assumes an investor makes a 25 percent down payment and finances 75 percent of the property (75 percent loan-to-value ratio.) As this comparison illustrates, the investor who performs a §1031 exchange acquires $592,000 more real estate than the investor who sold and paid taxes!

SALE

Equity: $600,000
- Taxes Owed: $148,000
After-Tax Equity: $452,000
x 4
New Property: $1,808,000

EXCHANGE

Equity: $600,000
- Taxes Owed: $0
After-Tax Equity:$600,000
x 4
New Property: $2,400,000

ADDITIONAL §1031 EXCHANGE BENEFITS

• Maximize return on investment
• Preservation of equity
• Increased cash flow from larger properties