Sunday, June 29, 2008

Avoiding The Latest Capital Gains Tax Proposal

Okay, a lesson in economics and tax policy.

Presumptive presidential nominee (for the democrats) Sen. Barack Obama, has proposed significant increases in the capital gains tax. Specifically, he would bump the tax 20-28 percent on people with incomes over $250,000. He has already said he plans to increase income taxes on higher income earners, but this discussion is about "capital gains."

This is a spike on whatever capital gains you receive in a given year. It could be on stocks, bonds, or whatever. Even the sale of real estate, though if you work with an experienced real estate investment adviser, these proposals should not affect you.

My personal belief is that if Mr. Obama wants to increase revenue, he should decrease the capital gains tax rate, not increase it. He disagrees, suggesting that rich people had no problem with a 28 percent rate when Bill Clinton was in the White House. Actually, he is wrong. And "rich people" is not defined as "the working poor" but most everyone else these days when you look at demographers, incomes and tax rates. But I digress.

There were complaints about capital gains taxes under Bill Clinton. And when he finally lowered it from 28 percent, under ever-increasing pressure from the republican-dominated Congress in 1997, investment capital tripled. Capital increased, and so did revenue to the government.

CNN Money reports Sen. Obama's proposal this way:

"Barack Obama has made one part of his plan for the capital gains tax perfectly clear: He wants to raise the rate above 15% for high-income investors.

"But to what level: 20%? 23%? 27%? All Obama has said is that it would be at least 20% and less than 28%.

"The choice the presumptive Democratic nominee for president makes will matter to investors and to federal coffers. It's one of the many crucial tax details he and his advisers have yet to settle as they campaign against Republican rival John McCain.

"One reason Obama says he wants to raise the rate is to establish more fairness in the tax system. A low rate directly benefits high-income taxpayers the most since they hold more taxable investments than everyone else."

Okay, I'm not going to suggest whom you vote for. I do not do that in this forum.


As an investor, or even as an aspiring investor, there is a way to defer capital gains altogether, indefinitely, whether you have a $75,000 annual income or a $1 million or more annual income. It is NOT a loophole, it is not a trick, it is not a fly-by-night accounting scam from a book written by people who are now in prison for practicing what they preach.

It's called investment real estate. Which I hope is why you are reading this blog. Its not a flip, where you get a chunk of change for profit (then have to pay taxes on it), and you don't have to own a giant apartment complex or pieces of downtown Cleveland or Atlanta.

When you take advantage of rule 1031 of the Internal Revenue Service Code, you have done something for yourself, your children and your grandchildren. An IRS 1031 tax-deferred exchange enables you to exchange one like/kind property for another. As you move up in value, as long as you indicate it is part of a 1031 exchange, you pay no capital gains tax.

Not just in theory, but in reality, investors will take a $20,000 initial investment (leverating the rest through bank loan) and put it in some piece of property. Perhaps it is 20 percent down on a $200,000 twin single. After five years, they put it up for sale. During that time their equity in the property has risen above the $20,000, plus the property has appreciated. Concurrent with the marketing of the property, the investor is looking for a replacement property and finds it in a 12-unit apartment building for $600,000. The sale is made, the exchange is announced to the IRS, and the equity is now moved into the larger property.

Another five years passes, the investor purchases a seven suite office building for 1.3 million. The apartment building sells for $800,000 or better due to some improvements made on the structure. During that time the investor's equity in the 12-unit apartment building rose as she paid down her debt.

In a little over 10 years, the initial $20,000 has parlayed itself into a $1.2 million investment portfolio. And during that time, not a dime in capital gains taxes was paid because the investor utilized IRS Code 1031.

If you want to take advantage of this opportunities -- carved into the tax code since the 1920s (it is set in stone and isn't going anywhere) -- BE SURE that you are using a real estate investment adviser who understands investment real estate. Who understands before-tax and after-tax income, who understands tax-deferred exchanges.

But most of all, understand that people who dabble in real estate lose tens of thousands of dollars every year and don't even know it. They think their flip made them a nice chunk of change, but in reality had they held the property for a while, they would have been building wealth instead of putting a little bit more cash in their pocket for the short term.

Sen. Obama and others have played with capital gains taxes for decades. But no one tries to touch tax-deferred exchanges.

Why? Because the investor class in this nation utilize it every day. But you don't have to be "ultra wealthy" (whatever that is) to exploit this rule yourself. It is there for everyone to use.

And if you don't utilize tax deferred exchanges, you really can't call yourself an investor. You're just playing in a minefield.