Some Owners May Not Enjoy Capital Gains Tax Cut

WASHINGTON — Don’t be misled by all the backslapping and bipartisan mirth on Capitol Hill about capital gains cuts and a balanced budget deal.

If you own any form of investment real estate--a rental condo at the beach, a duplex downtown, a small apartment building--the tax-cut outlook is more somber than you may think. There are two proposals afoot that spell bad news for real estate investors.

First, new federal budget documents reveal that the revenue shortfall caused by eliminating capital gains taxes on home sale profits up to $500,000 would be more than paid for by a previously unannounced Clinton administration plan to raise taxes on another real estate transaction--tax-deferred exchanges.

The proposed restriction on exchanging would tighten the definition of “like-kind” property that can be swapped without paying capital gains taxes.

Second, a little-publicized $5-billion-to-$10-billion revenue-raising plan under serious consideration by congressional tax writers could render a capital gains reduction virtually meaningless to owners of income property.

Realty Sellers Would Pay Two Tax Rates

Here are the details:

House Ways and Means Committee Chairman Rep. Bill Archer (R-Texas) and other Republicans are determined to cut the federal capital gains levy to 19.8% this year as part of the balanced budget deal with the Clinton administration.

But Capitol Hill sources say Republican tax writers are actively exploring a concept that would deny full use of the 19.8% rate to many rental and business real estate owners.

The plan would allow the new, low rate to be used only on those gains on a sale that represent an actual increase in the price or market value of the property since the seller acquired it.

The current 28% capital gains rate--not the new, lower rate--would be imposed on all realty investment gains attributable to depreciation deductions taken by the sellers during their time of ownership.

In effect, real estate owners would become second-class citizens under the federal tax code. Where sellers of stocks and bonds would be taxed on their gains solely at the 19.8% rate, real estate sellers would be hit with two rates--19.8% and 28%. The rule would affect most small-scale rental property owners, but would be particularly tough on longtime owners.

Here’s a simplified example. Say you bought a rental property for $100,000, made no capital improvements, took $25,000 in depreciation deductions and sold it for $125,000. Your taxable gain is $50,000--$25,000 on the sale and $25,000 in depreciation, which lowers your tax “basis” in the property and is recaptured at the prevailing capital gains rate.

Under the proposed plan, you’d pay a 28% rate on the $25,000 depreciation recapture ($7,000), and 19.8% on the $25,000 resale profit ($4,950). The total tax would be $11,950, which works out to an effective “blended” rate of about 24%.

Why are congressional tax writers so interested in a plan that would treat one category of capital asset--real estate--differently from all others?

The key reason, say Capitol Hill staff members: It would raise big bucks for the Treasury and help pay for a big chunk of the $30-billion-plus estimated cost of a broad-based capital gains cut.

The theory, say tax analysts, is that any lower capital gains rate would entice real estate owners to sell--even if the effective rate they paid wasn’t as low as what’s paid by stock sellers.

But for large numbers of rental property owners--especially in large urban markets--the plan could represent no enticement whatsoever.

For many small-scale rental home and business property owners who bought during the last 10 to 15 years, there’s been relatively little increase in market values from when they first purchased.

The outlook? The proposal is certain to provoke a fight when the tax committees begin writing their bills in June. Twenty Ways and Means committee Republicans already have asked Archer to drop active consideration of the plan. So far, he’s been mum.

Tax-Deferred Swaps May Get Tougher

New fiscal 1998 budget submissions to Congress repeat the president’s campaign promise of tax relief for home sellers, costing the federal Treasury an estimated $1.43 billion in tax revenues over the next five years.

But tucked away in a different section of the budget is a proposal the president never mentioned in his capital gains reform plank--an effort to rein in realty exchanges by sharply narrowing the types of property eligible for tax-deferred swaps.

The latter proposal, if enacted by Congress, would bring in an estimated $1.8 billion in new federal tax revenues during the coming five years--$400 million more than the revenue cost of home sales tax relief. In effect, said one congressional committee staff member, the president “wants to look like a tax-cutting hero to one segment of the real estate-owning community,” but in reality intends to raise net federal taxation of real estate.

The proposed restriction on exchanging would tighten the definition of “like-kind” property.

Under Section 1031 of the Internal Revenue Code, first enacted in 1924, owners of real estate held for investment or business use can exchange their interests without federal capital gains taxation, even if the property has increased substantially in value since acquisition. Section 1031 allows exchangers to defer recognition of their taxable gains until they accept cash or other payment for the property.

The Internal Revenue Service historically has taken a broad view of what constitutes “like-kind.” For example, current IRS rules allow you to swap a New Jersey beachfront condo for pineapple acreage in Hawaii, or an apartment building in Miami for mineral rights in West Virginia.

The relative ease of matching up seemingly dissimilar types of property has made Section 1031 popular as a financial and estate-planning tool for a wide spectrum of taxpayers, from mom and pop rental duplex owners to megabucks corporate real estate developers.

The Clinton administration’s proposal would shrink the definition of “like-kind” to “similar or related in service or use.” Under this standard, unimproved land could never be exchanged for any form of improved real estate. Nor could properties with distinctive uses--say, a resort condo unit--be swapped for an interest in any commercial-use form of real estate, like a retail store.

Tax attorneys active in the real estate field say the change would prohibit a large percentage of the multi-part exchanges that occur today and would be particularly harmful for small-scale real estate owners heading for retirement.

Stefan F. Tucker, a Washington, D.C., tax lawyer, says the Clinton plan “is really going to take away a lot of equity from small players,” forcing them to pay out one-third or more in combined federal and state capital gains levies because they had to sell, not exchange.

For example, rather than allowing a farm owner on the suburban fringe of a Northern metropolitan area to trade his acreage for a suitable Sun Belt business or investment property he could manage in his retirement years, “you’re going to force him to pay 33% to 34% of just about everything he owns in taxes” and greatly limit his retirement options, said Tucker.

New Limit on Finding Replacement Property

The budget submission does include one proposal that exchange advocates see as genuine simplification. It would eliminate the current 45-day limit for a deferred exchange participant to identify a qualified “replacement property.”

Instead, the taxpayer would have the later of 180 days or the due date for the taxpayer’s income tax filing for the year, to acquire the replacement.

What’s the outlook on Capitol Hill for the president’s exchange proposals? Murky at best.

On the one hand, Republicans on the House Ways and Means Committee aren’t eager to complicate the Section 1031 rules. But on the other hand, they want Clinton to back their plan for an across-the-board cut in capital gains taxes--a costly and far-reaching campaign plank that many Republicans ran on last year.

If the administration insists on passage of revenue-raising proposals--like 1031 restrictions--as part of the price of capital gains reform, the Republicans may well trade away those chips.

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Distributed by the Washington Post Writers Group.