How Low Can You Go? New Capital Gains Tax Rates Pose Interesting Choices for Exchangers

Article excerpt

When President Bush sent his tax bill to Congress in early 2003, media and political scrutiny focused on the proposed elimination of taxation on dividends. That proposal was a bold and controversial stroke, but one completely consistent with economic theory about the taxation of capital. For more than 40 years, critics of the tax system have believed the Internal Revenue Code imposes burdensome taxes that impair capital formation.

What emerged from Congress substantially reduced taxes on capital but is different from what the President originally proposed. The bill Congress sent to him for signature restructures both capital gains and dividends taxation. For the first time, dividends are to be taxed separately from other income and at a very low rate. Also, new capital gains rates and dividends will be taxed at the same 15 percent rate. For the first time in memory, some investors may determine it is advantageous to sell property outright, recognize their gains and pay their tax, a major change from the popular transaction structure of deferred like-kind exchanges.

The like-kind exchange provisions are unchanged. The 45-day and 180-day requirements still apply, and the investor continues to have a carryover basis in the replacement property acquired in the exchange. The newly reduced capital gains rate may make outright sales more advantageous to some. A simplified example illustrates the new decision-making process.

Investor A owns Building One, with a basis of $2 million. A sells Building One for $5 million, realizing a gain of $3 million, then acquires Building Two for $7 million. If A has satisfied all riming and other requirements, this transaction could be treated as a deferred exchange and A would defer taxes on the $3 million gain. …