Pay Capital Gains Taxes Now or Later?
In helping our clients develop and implement their optimal exchange strategy, we occasionally are asked whether it is better to pay capital gains taxes now rather than to defer them until a later time. The prospect of higher capital gains tax rates does indeed loom on the horizon and seems especially likely if we end with a Democratic congress and a Democratic White House. Having said that, one has to wonder how big of an increase could realistically be expected given, among other factors, the effects it could have on the economy and the intense lobbying effort in opposition that will inevitably occur.
So, under what circumstances would it make sense to pay the tax now rather than defer it? The answer is a function of several variables – the cost of money, the amount of the expected increase and the length of the potential deferment. Also, everybody seems to have different circumstances that can make such an assessment more difficult.
We’ve attempted to create a simple but somewhat realistic example that illustrates the effects of the parameters listed above on the analysis. Feel free to modify this to suit your circumstances. We take no responsibility for the accuracy of what follows or for the consequences of any decision made based on our model.
Assumptions:
- An Old Property is being sold and a New Property is being bought, although not necessarily in that order.
- A 1031 exchange is being contemplated. When the Old Property is sold, there will be a taxable capital gain if the 1031 exchange is not done. We assume that the New Property is acquired in either case.
- The following numerical parameters are part of the calculation:
- The gain (G) on the sale of the Old Property is $1,000,000.
- The taxpayer is an individual and the current tax rate (C) on long-term capital gains of 15% applies.
- At some future point, there will be a new tax rate (F) that will be applied to long-term capital gains.
- There is a cost of funds (M) that applies to the money required to replace the tax, since it is assumed that a New Property is being acquired.
- There is a length of time, in years (Y), that is the hypothetical period where the exchanged New Property is held before it is sold and the capital gain tax is paid.
For the example, suppose the following specifics
- A potential gain of $1,000,000 (G = $1,000,000)
- A current tax rate of 15% (C = .15)
- A future tax rate of 20% (F = .20)
- A cost of money of 5% (M = .05)
- A holding period of 7 years until the New Property is sold and the tax paid (Y = 7)
If the decision is made to do a 1031 exchange and defer the tax, then paying the tax after 5 years will result in a $50,000 increase in taxes ($200,000 vs. $150,000)
If the decision is made to pay the tax and find money elsewhere to replace the $150,000 in taxes, then the cost of money after 7 years will be $52,500.
In this case, it is better economically to do the exchange and defer payment of the tax.
In cases where the hold period is shorter, with all the other parameters remaining the same, it would be better to pay the tax.
If the increase in the capital gains taxes is less than 5% for individuals, then paying the tax right away becomes significantly inferior to deferring the tax.
As you can see, the situation is dynamic. We provide a simple spreadsheet, available by clicking here or from Downloads, which allows you to plug in your own set of parameters, using the framework above, to determine the optimal strategy for your situation.