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Capital Gains Problems? Pay or Play!

By John Dietz - Email Editor

Date : September 2, 2008

Dear Valued Reader,

Recently in July, a new bill was signed that entitled the Housing and Economics Recovery Act of 2008 and the changes to IRS Tax Code 121. This bill specifically addressed capital gains (read the article here). The capital gains qualification for tax-exempt exclusions when selling property are now more difficult to qualify for, regardless of whether the property is investment property or residential.

So we prefer to advise you to play (this does not mean don’t pay your taxes), since we are advocates for building a client’s net-worth. You first need to understand the concept of depreciation.

Depreciation is a non-cash expense that reduces the value of an asset. The amount of reduction depends on the nature of the asset, the wear and tear, the decline or obsolescence and how the legislation or IRS Tax Code determines the limits. Depreciation is balanced against profits and can be used to increase cash flow. Depreciation can be used as a tool to avoid a “tax trap.” A “tax trap” is the occurrence of due taxes when the taxpayer had no preparation or forethought for the due taxation.

Depreciation is so complicated that many people overlook the advantages and further depreciation that may be coordinated with other mortgage management tools such as Equity Harvesting and HEAP for mortgage acceleration. Here is a list of questions from IRS Code Section 179 that you should discuss with your accountant.

We will look at the process of selling a property that was an investment property rather than the personal residence (the personal residence has more options, which we will discuss in the following paragraphs).

During the life of a rental property, you must depreciate the value every year when you pay taxes. When a person has “rental income”, they use depreciation to increase their cash flow. When they sell the property, the depreciation must be “recaptured” or added back to the fair value of the property often leaving a large capital gains tax of 15 percent and a depreciation recapture tax of 25 percent. It would seem that depreciation isn’t a great solution after all, so let’s call it a “motivator” and look for creative outlets and solutions.

Here is an example of how the “recapture of depreciation” works from Section 179 IRS Tax Code.

If, during the 5-year period ending on the date of sale, you owned the home for at least 2 years and lived in it as your main home for at least 2 years, you can exclude up to the maximum dollar limit. However, you cannot exclude the portion of the gain equal to depreciation allowed or allowable for periods after May 6, 1997. This gain is reported on Form 4797 (PDF), Sale of Business Property. If you can show by adequate records or other evidence that the depreciation allowed was less than the amount allowable, the amount you cannot exclude is the amount allowed.

Depreciation is mandatory; the taxpayer does not have an option. Therefore, you guessed it, depreciation recapture taxes will be calculated and assessed by the Internal Revenue Service whether or not the taxpayer actually took the depreciation.

Now that you understand this, in the next newsletter, I will discuss the “play” options on how you can avoid these capital gains taxes. We will discuss how 1031 Exchanges, Equity Harvesting and HEAP, all of which address this situation, directly and indirectly can become viable tax tools in Estate Planning and investment.

Until next time,

John

John Dietz
TrustMakers.com

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