Is Uncle Sam giving us another tax break?  Well, sort of.  On May 28, 2003 the President approved a $350 billion tax bill offering $330 billion in tax breaks to families, businesses, and investors and $20 billion in state aid.

Included in the new tax law is a reduction of the long-term capital gains tax.  Specifically, under the new legislation, the highest tax rate on long-term capital gains is now only 15% compared to the previous 20%.  The new rates are retroactive to May 6, 2003.  Gains included in installment payments received on or after May 6, 2003 from earlier deferred payment sale transactions are also eligible for the new 15% rate.

As investors you should be aware however, that the gain attributable to depreciation deductions claimed against property is still taxed at a maximum rate of 25%, and short term capital gains (i.e. those held for one year or less) remain taxable as ordinary income.

Even with the lower capital gain rates, as an investor, you should first determine your total tax liability before selling real estate.  Often the impact of depreciation recapture at 25%, plus the combined federal and state tax owed, result in a section 1031 tax deferred exchange being a much better alternative.  In fact, when analyzing the purchasing power of an exchange as compared to a sale, the value of tax deferral becomes even more dramatic.

We here at Gandhi & Associates, Realty are knowledgeable about the issues of Capital gains Taxes and Tax deferred exchanges and would therefore like to assist you in understanding possible alternatives for you investments.  To help you appreciate what the difference from selling your property versus reinvesting your money in terms of the monetary value of your investment, here is an example: 

Assume you, the investment property owner, sells a rental property for $700,000.  You originally purchased the property for $200,000.  There is $100,000 of debt and the property has been fully depreciated (assuming 80% of the property is depreciable).  You have $500,000 of capital gain plus $160,000 of depreciation recapture (which if you recall from above is 25%).  Also, you are in the top federal tax bracket of 15% and your 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 this Sale:

                                    = $148,000

Let us continue with this example to show you that the major benefit of an exchange vs. a sale is not the actual savings, but the purchasing power provided by this tax savings.  With a Tax Deferred Exchange you are holding of on paying taxes till further down the road, which enables you to have more money for better leverage and greater investment returns.  The following comparison shows the value of a new property that could be acquired in an exchange versus a sale.

Assume you now make a 25% down payment and finance 75% of a new property (75 % loan-to-value ratio).  The comparison illustrates that if you perform a section 1031 exchange you acquire $592,000 more real estate than if you just sell and pay taxes!!!!

                    SALE            EXCHANGE

Equity:                        $600,000       $600,000

Minus Taxes Owed:   $148,000     $0.0____

After-Tax Equity:      $452,000       $600,000

                                    x 4                  x 4    

New Property:     $1,808,000   $2,400,000 

($2,400,000 - $1,808,000 – $592,000)

Again we understand that this example along with these figures may seem somewhat confusing or

overwhelming to you, thus feel free to give me a call and I shall be happy to explain this to you with further detail that would be more realistic to you and your investments.

Along with the greater return from reinvesting your equity, there are other recognizable benefits offered by a section 1031 such as the ability to consolidate or diversify investments; the ability to realign a real estate investment portfolio; the ability to increase cash flow from larger properties; the ability to maximize return on investment and the ability of preservation of equity. 

The recently enacted Jobs and Growth Tax Relief Reconciliation Act of 2003 decreases the tax rate on capital gain and dramatically decreases the tax rate on dividends.  These provisions are complex thus I invite you to meet with me to discuss their impact on you. 

The information is intended to let you know of some of the recent changes but, of course, is not a substitute for professional tax advice. 

I would be happy to discuss the provisions of the 2003 Act with you to be sure that you receive the full benefit of the new changes in the law.   

Please contact me at your convenience to arrange a meeting. Give me a call at Gandhi & Associates, Realty (650) 588-2524 or contact me via email: gandhi@gandhirealty.com.