Approximately ten years ago Congress passed sweeping tax cuts proposed by President Bush. These cuts were wide ranging and included everything from estate taxes, ordinary income tax rates, alternative minimum tax, itemized deductions, and, the most important one for real estate investors, capital gains tax. Capital gains tax is essentially a tax on appreciation. If a home is bought for $100,000 and then sold for $150,000 the $50,000 gain on that investment can and will be taxed. For the sake of this discussion we are not talking about a primary residence, just homes held as investments.
If Congress does not do anything to extend those cuts before the end of the year, and it appears they will not, long and short term capital gains tax rates will revert to pre-2001 rates. Gains on investments held for more than one year (long term) are currently taxed at 15% for anyone not in the two lowest tax brackets which is the case for most people who invest in real estate. If the cuts are allowed to expire at the end of this year, long term capital gains will be taxed at 20%.
While long term capital gains are taxed at a rate that has little to do with an investor’s level of income, tax on short term capital gains is figured at the ordinary income tax rate of the tax payer. This means that an investor who is taxed at a rate of 28% on ordinary income such as wages will also be taxed at a rate of 28% on short term gains. On January 1st of next year ordinary income tax rates (and by extension, taxes on short term capital gains) are set to rise by 3% to 5% depending on your tax bracket. In real estate, short term gains are most often realized by “Flippers” who buy and sell a property in less than 12 months.
These tax increases could affect the real estate market but I would expect any repercussions to be relatively short-lived. For example, an article in USA Today suggests that a recent increase in sales at the luxury level of the real estate market could be driven, in part, by the pending expiration of the Bush tax cuts. If the threat of a tax increase is driving high end sales now it should disappear in four months when it is no longer just a threat. After the beginning of the new year there may be a wait and see attitude from sellers but most of what they will be waiting on is to see how election results will influence taxes and that should be fairly obvious after the elections in November. However, another ineffective Congress could drag things out for some time.
Investors considering a sale in the next twelve months would be wise to consult with their Realtor® and tax accountant now. Find out how much gain (appreciation) there is on the property and what the tax consequences are for selling now versus selling next year and realizing gains at a potentially higher tax rate. If it makes sense to sell now there is still plenty of time to make a sale happen before the end of the year.
This post should not be considered to be tax advice. It is meant to inform the reader about possible changes in legislation that could affect real estate investors. For the most up to date information regarding taxes and the IRS you should consult your accountant or tax preparer.