Capital Gains: It's a Brave New World

The good news about the capital gains tax cut is that every property will experience a lower capital gains tax rate. The bad news is that the effective capital gains tax rate could vary by up to almost 5 percentage points from property to property.

The complicating factor that Congress placed into capital gains tax relief for real estate is the differing tax rates for real and depreciation recapture capital gains-20 percent and 25 percent, respectively. (Real capital gain is the profit-the sales price above the original purchase price. Recapture capital gain is the cumulative depreciation subtracted from operating income for the years a property was in operation.) The capital gains tax law also increased the holding period from 12 months to 18 months.

Previously, Section 1250 of the Internal Revenue Code applied the same tax rate, 28 percent, to real and recapture gain. Consequently, the effective capital gains tax rate was equal for all asset categories. Under the new rules, the effective tax rate for real estate will be a blended rate of between the 20 percent real gain tax rate and the 25 percent recapture tax rate. However, since other asset categories such as stocks and bonds are not subject to recapture, their capital gains tax rate of 20 percent always will be lower than real estate.

The National Association of Realtors (NAR), in close consultation with the Commercial Investment Real Estate Institute, spent more than $1 million in an intense lobbying and grass-roots effort to maintain parity between real and recapture capital gains tax rates. Although NAR was unsuccessful in achieving equal treatment for real estate assets, the 3 percentage point reduction in recapture capital gain will save the industry $3 billion in capital gains taxes. The reduction in the recapture gain rate from 28 percent to 25 percent represents a 10.7 percent decline.

How will the differing capital gains tax rates affect real estate? The question can be answered by examining three scenarios: fully depreciated property with small real gain; partially depreciated property with significant real gain; and newly acquired property with little depreciation and strong appreciation (see chart).

Each scenario assumes a purchase price of $1 million. In scenario 1, a property held on a long-term basis that experienced little appreciation and is fully depreciated would have the highest blended tax rate of 24.5 percent. The high blended rate would be close to the recapture capital gains tax rate due to the lack of appreciation. Unfortunately, data compiled by the National Real Estate Index reveals that properties purchased in 1985 and sold in 1996 have appreciated by only 2 percent. Due to this low level of appreciation, buildings purchased during the pricing peaks of the mid-1980s are unlikely to experience tax relief significantly greater than the 25 percent recapture capital gains tax rate.

Scenario 2 assumes equal depreciation and appreciation of $250,000. Under this scenario, the blended tax rate would be 22.8 percent. This rate reflects a significant reduction from the previous rate of 28 percent.

Scenario 3 represents a building purchased two years ago that has undergone a dramatic increase in value due to low purchase price and very strong price appreciation. The low level of depreciation is based on a two-year hold. In this example, the 20.5 percent blended tax rate is close to the real gain tax rate paid by stocks and bonds.

From scenario 1 to 3, there is a 4 percentage point differential in the blended tax rate. This large differential shows the growing role that tax planning will have in future purchase and sales decisions. Generally, the new recapture tax scheme favors shorter-held assets because they are subject to the higher 39-year tax depreciation schedule, which results in a lower recapture tax burden. However, strong price appreciation lowers the blended tax rate for all ownership tenures.

This analysis has addressed only the 20 percent real gain tax bracket. Special rules that become effective after December 31, 2000, will provide 18 percent real capital gains rate (8 percent in the 15 percent bracket) for assets held five years or longer. However, no property sold before January 1, 2006, will qualify for the 18 percent rate.

Despite the complexity of the new capital gains tax rules, property owners will benefit across the board from lower capital gains liability. Mastering the new capital gains tax law will position commercial real estate professionals to become direct beneficiaries of the increased transaction volume that lower capital gains tax rates should generate.

Capital Gains' Effect on Real Estate
Characteristic Scenario 1 Scenario 2 Scenario 3
Purchase price $1,000,000 $1,000,000 $1,000,000
Sales price $1,100,000 $1,250,000 $1,500,000
Real gain $100,000 $250,000 $500,000
Real gain tax rate 20.0% 20.0% 20.0%
Real gain taxes $20,000 $50,000 $100,000
Recapture gain* $800,000 $250,000 $41,026
Recapture tax rate 25.0% 25.0% 25.0%
Recapture taxes $200,000 $62,500 $10,256
Blended tax rate** 24.5% 22.8% 20.5%
* Recapture gain equals cumulative depreciation.
** The blended tax rate is calculated by the formula [(recapture rate x recapture taxes) + (real gain tax rate x real gain taxes)]/(recapture taxes + real gain taxes).

George Green

George Green is a policy representative/senior economist for investment real estate at the National Association of Realtors in Washington, D.C.