Colorado Real Estate Journal - March 18, 2015
President Barack Obama’s proposed budget was released Feb. 2. The administration’s budget contains a number of tax increases and significant limitations to Section 1031 tax deferred exchanges, projected to raise $320 billion in new revenue. The president’s proposals would, if enacted, have a significant impact on real estate investors. -Increase in capital gain tax rate. The president has proposed increasing the top capital gain tax rate from 20 percent to 28 percent. Under current law, many real estate investors in the top tax bracket face an additional 3.8 percent tax on net investment income under IRC Section 1411, resulting in a total tax rate of 23.8 percent. Under the proposal, this would increase to 31.8 percent. -Elimination of stepped-up basis at death. Under current tax law, when a taxpayer dies, the taxpayer’s heirs receive a step up in the basis of inherited property. The basis is stepped up to the fair market value of the asset on the date of death. The president has proposed eliminating this stepped-up basis, which will result in the built-in gain remaining in the property after it passes to the heirs. Although the proposal has some small exclusions ($200,000 on general asset gains and $500,000 for a taxpayer’s primary residence), eliminating the stepped-up basis would seriously impact the heirs of investors who die with appreciated assets. -Limiting tax deferral on real property exchanges to $1 million per taxpayer annually. The good news is investors still have the opportunity to take advantage of the current tax code and achieve tax-deferral benefits today. IRC Section 1031 tax-deferred exchanges have been a part of the tax code since 1921. Section 1031 allows an investor who holds property for investment purposes, or for use in a trade or business, to defer all four levels of potential capital gain taxes (federal capital gain, federal depreciation recapture, net investment income and state capital gain) by exchanging for qualifying likekind property under Section 1031. By deferring the capital gain tax, an investor has significantly more purchasing power and better overall investment returns. Let’s compare the tax treatment for the sale of an investment property between: (i) paying all the taxes owed, or (ii) using a 1031 exchange to defer 100 percent of the taxes owed. We will assume the property has total capital gain of $1.3 million, $300,000 of which is from depreciation recapture and $1 million of which is from asset appreciation. For this example, we will assume this is a Colorado investor who has a 4.63 percent state tax rate, and we will assume the investor is also paying the 3.8 percent net investment income tax on the entire capital gain. Assume the investor in the previous example sold the relinquished property for a total net sales price of $2 million, with, as stated above, $1.3 million of total capital gain. Assume the investor intends to apply the sales proceeds toward a 25 percent down payment on a replacement property, with conventional financing for the remaining 75 percent of the replacement property purchase price. We will compare how much property the investor who sells and pays all the taxes can purchase versus how much property the investor who exchanges and defers 100 percent of the capital gains tax can purchase. Sell in 2015 and pay taxes: ($2,000,000 - $384,590) = $1,615,410 x 4 = $6,461,640 Exchange in 2015 and defer taxes: ($2,000,000 - $0) = $2,000,000 x 4 = $8,000,000 By taking advantage of a 1031 exchange, the investor defers all taxes, thus preserving his net sales proceeds for the purchase of better performing replacement property. In this comparison, the investor who exchanges versus sells is able to purchase a replacement property worth considerably more. This information is not intended to replace qualified legal and/ or tax advisers. Every taxpayer should review his specific transaction with his own legal and/or tax counsel.