To exchange or not to exchange? — that is the question

Filed under: Contributed Columns |

Even with capital gains rates at historical lows, taxpayers always seem to want to defer the payment of tax.
Many real estate investors use the strategy of a 1031 Exchange to accomplish this deferral if they are going to continue their investment in real estate. But the recent presidential debates have raised questions about the future of these capital gain rates.
Will a new administration bring changes to the historically low rate of 15 percent? Most, if not all, of the Democratic candidates have suggested an increase as part of their platform, while most of the Republican candidates have suggested retaining or even reducing the rate.
In Colorado, we are also blessed with yet another tax saving feature — the Colorado Capital Gain Exclusion. In general, this feature allows Colorado taxpayers to sell real estate completely free from state income taxes if the property was purchased after May 9, 1994, and if it has been held for more than five years.
There are other restrictions to qualify for the Colorado Exclusion, but as time passes, this law will encompass more properties. As the state continues to struggle with its budget and more Colorado taxpayers take advantage of this exclusion, it too might be revisited by lawmakers.
So what’s a real estate investor to do? The general rule has always been “defer tax at all costs.” Maybe that’s not the best strategy today depending on what your political crystal ball is telling you.
Let’s consider a few scenarios to illustrate the possibilities. Assume you purchased a piece of investment land for $200,000 during 1998, and could sell it for $300,000 today (i.e. $100,000 capital gain).
Scenario No. 1: You choose to sell the land today and just pay the tax (i.e. no 1031 Exchange). You’d likely pay $15,000 in federal tax and no Colorado tax, assuming you meet the other qualifications for the Colorado Exclusion.
Scenario No. 2: You choose to sell the land and defer the gain using a 1031 Exchange. Then, let’s assume you sell the replacement property during 2010, recognizing the same $100,000 of gain that you deferred. What if the capital gains rate has increased to 28 percent (the old “favorable” capital gains rate)? Assume Colorado lawmakers do away with the Colorado Exclusion. In this scenario you’d likely pay $28,000 in federal tax and another $4,630 in Colorado tax, for a total of $32,630.
Scenario No. 3: Same as No. 2, except let’s assume lawmakers actually reduce the capital gains rate to 10 percent, and Colorado keeps its Capital Gain Exclusion. In this scenario, you’d likely pay $10,000 in federal tax and no Colorado tax.
As you can see, in scenario No. 2, you might have deferred the tax for two years, but more than doubled your tax bill in the process. With that outcome, paying the 15 percent tax bill during 2008 starts to look a lot better.
Then again, in scenario No. 3, you may have deferred the tax bill for two years and saved some tax in the process.
As you can see, the outcome is dramatically different when changes in tax rates are contemplated. No longer is “deferral” the only variable in the equation.
As with any complex area of the tax law, you should always consult your tax adviser regarding 1031 Exchanges and the Colorado Capital Gain Exclusion. But, given the active political environment regarding taxes on capital gains, you might want to involve your political adviser in the process as well.
Greg Gandy CPA is tax director at BiggsKofford P.C. He can be reached at or 579-9090.