Some Recent History
Recent history provides some perspective of where we are and
where we may soon be heading. In order to stimulate the
economy, the trend over the past ten years has been to decrease
long-term capital gains rates for individuals. Bill Clinton
decreased it from 28% to 20%, and George Bush, as part of his
overall tax cuts, decreased it again in 2003 to its lowest level in
recent times of 15% for individuals. Capital gains tax rates for
corporate and other non-pass-through entities remained at 35%.
This 15% tax rate was intended to be short-term, extending only
until 2008, but again, keeping with the trend to keep taxes low,
the Republican majority congress and President Bush extended
the expiration date to 2010. This trend, however, may now be
shifting.
Why are Capital Gains Rates Likely to Rise?
In March 2008, the newly Democratic majority Congress
rejected an extension of the Bush tax cuts past 2010. After 2010,
the tax cut will expire, and beginning in 2011, the tax will
increase to a minimum of 20%, and perhaps higher. Barack
Obama has indicated, that if elected President, he will consider
raising the tax to 28%. The effects of such an increase will likely
be significant.
To begin with, it is certain that sales of commercial properties,
absent legitimate tax deferral strategies, will result in lower
actual after-tax proceeds, which will significantly reduce the
overall internal rate of return (IRR).
As a point of illustration, the following chart depicts the results
of a property acquired for $10.0 million, which returns an annual
8% return on investment, with 3% annual growth. If held over a
ten-year period, an increase in the capital gains tax rate to 28%
will result in a leveraged IRR reduction of 95 basis points, or
7.6%. When comparing the results over a five-year period, the
reduction balloons to 132 basis points, or 10.0%. Certainly not
an insignificant number.
These projections may encourage investors to react in ways not
necessarily beneficial t