by Joel S. Hinckley
Capital gains tax can be a considerable source of revenue for state and federal governments.
The capital gains tax on real estate has been a part of the tax code in the United States ever since it first had a tax code. Essentially, any time a property is sold for more than it was purchased for has experienced a capital gain due to appreciation. This gain is taxed by the federal government and by most state governments. Knowing what your tax burden may be, or at least understanding what this tax is, may inform purchase and sale decisions for real estate investors.
Federal Capital Gains Tax Rate
The federal capital gains tax rate is 15 percent and will remain so until the Bush tax cuts expire at the end of 2010. At that point the tax should return to its previous rate of 20 percent.
State Capital Gains Tax Rate
Any property with improvements can be depreciated annually on your taxes for a tax benefit. The IRS has included a provision with capital gains tax that provides for an opportunity to recapture a portion of the benefit you've enjoyed down through the years while owning your property. Depreciation recapture is a tax of 25 percent on the amount of depreciation you've realized during the time you've owned the property.
Avoiding Capital Gains
There are three ways to avoid capital gains tax. The first is to never sell your property. The second is to die before your property is sold. If this happens, your estate will inherit the property with no capital gains accrued to it, as you were the one who experienced the gain. If your heirs sell the property immediately for the current market value, then no capital gains tax will be levied. The third is the most practical and it is known as a 1031 exchange. This is simply a method of using the proceeds from the sale of your property to purchase a new property for an equal or greater value when compared to your previous property. This way, you can defer the tax until you sell the new property. There is no limit on the number of times you can use a 1031 exchange in your lifetime.
Benefits of 1031 exchange
Obviously, a 1031 exchange can allow you to indefinitely delay or postpone the payment of capital gains tax. However, there are other advantages, as well. Using a 1031 exchange creatively, a real estate investor can use the proceeds from the sale of one property to purchase two separate properties of a combined value that is equal or greater than that of the property sold. This allows for greater diversification in the re-employ of your capital.
Capital Gains Tax History