Debunking the Coming “2008 Tax Boon"

by Bruce Jones

Here is a question I recently received from a friend and thought it very important to pass it on to you along with an explanation:

“I've heard that 2008 is a free year for capital gains. A friend of my mine said one can sell in 2008 with better tax breaks. Do you know anything about that?”

The capital gains taxes due on property sold in 2008 can be ZERO. Pretty exciting news! However, the reality is something far different and although what my friend heard is true, it IS NOT TRUE for the vast majority of property owners.

President Bush’s sweeping tax law change in 2003, the Jobs & Growth Tax Relief Reconciliation Act of 2003, had a significant impact on capital gains taxes. The 20% capital gains tax rate, for example, reduced to 15% for properties held past one year. And assuming your total income in the year of sale keeps you within a 15% or less federal income tax bracket, the capital gains tax rate reduces to only 5% for this year and ZERO in 2008--a virtual boon in added profit! Or is it? Let’s inspect this “windfall” a little more closely for those who qualify for this reduced tax rate and discover the “other side” to this story.

Taking a cursory look at this law, one would naturally assume that any capital gain for people who fall within a 15% federal income tax bracket would be taxed at a mere 5% flat rate this year. If you sold an apartment building, for instance, after owning it for more than one year and realized $100,000 in capital gains, you would only owe $5,000 in taxes. This would leave $95,000 in net after-tax profit to enjoy. And in 2008, the taxes would be eliminated entirely leaving the full $100,000 as profit. WRONG! Here is how it really works.

The current 5% long-term capital gains tax rate only applies when the total taxable income, INCLUDING the capital gains, does not exceed the maximum income to qualify for the 15% income tax bracket. This means that your total taxable amount for 2007, including capital gains, cannot exceed $30,650 if you file your tax return individually or $61,300 if you submit a joint tax return. Any taxable gain above these threshold marks will still expose you to the 15% capital gains tax rate. The same holds true in 2008 if the tax bracket threshold amounts remain the same.

Here is an example:

Retired with a $12,400 joint taxable income, a retired couple wants to sell their apartment building for the $1.1 million offered by a pending buyer. Their taxable income qualifies them for the 5% capital gains tax rate this year and if they choose not to close escrow until 2008, they would capture the ZERO tax next year. The capital gains exposed to taxes total $811,000. Mistaken, they thought their federal capital gains tax would be $40,550 ($811,000 X 5%) and zero next year. Neither is true.

Remember that $61,300 joint threshold mentioned earlier? It comes into play when taxes are calculated. The difference between the expected taxable income of $12,400 for this year and the $61,300 threshold is all that is taxed at the 5% rate. This yields a base tax of $ 2,445 on $48,900 ($61,300 - $12,400 taxable income X 5%). That leaves the client with a projected $749,700 still exposed to the 15% capital gains tax rate ($811,000 - $48,900 X 15%) causing $112,455 in additional taxes. This brings the total projected capital gains tax bill for 2007 to $114,900 and gives them an overall capital gains tax rate of 14.2%!

In 2008, the $48,900 taxable gain subject to the 5% tax rate would be eliminated and provides that much more profit in the client’s pocket. However, they would still be subject to the 15% capital gains tax rate on $762,100 and have to pay taxes of $114,315. This is still an overall effective federal tax rate of 14.1%.

Add to this the fact that California has no capital gains tax and all capital gain is recognized as normal income earned. Consequently, these folks’ tax bill will increase this year or next by another $75,423 because it throws them into the highest state marginal tax bracket of 9.3%. Their combined federal and state tax bill if they sold this year would be a whopping $190,323 and a little less in 2008!

When it comes to financial affairs, three things are guaranteed to change at some point in time: the economy, one’s own objectives and the tax laws. As tax laws change, can anything effective be done to solve the property owner’s tax problem and provide them greater tax and income benefit than what they have by owning the property? Absolutely! But it is important to first get a true picture of the tax problem then find the solution by following a defined common sense planning process. For any property owner who is pondering the sale of appreciated property, it should be no other way.

About the Author...

Bruce Jones has been an instructor of tax management and financial planning since 1974. He is President and CEO of TaxWealth®, a tax advisory company which provides comprehensive tax and estate solutions for owners of real estate and privately-owned businesses. Headquartered in Newport Beach, California, TaxWealth® works with clients and professional affiliates nationally. Visit their website at www.taxwealth.com or call toll-free at (800) 300-4723 ext. 14 for a free consultation to discuss your tax concerns.