Wednesday, August 16, 2006

If it sounds too good to be true, Change tax professionals

Let me pose a scenario and see if it sounds a bit too good to be true.

Sal makes 15K per year at his job. He owns a rental property he purchased for 100K five years ago and is selling today for 600K. Let's just say his capital gain including all improvements, depreciation, and after all costs of sale is 450K. (I'm keeping it simple for this example)

Sal goes to his local tax person, and this guy tells Sal that since he is in a low tax bracket (his income spans the 10-15% federal brackets) he will only owe 5% to the federal government in capital gains tax on his 450K gain. After all, capital gains are not considered ordinary earned income, and the 15% rate kicks in at the 25% and above Federal bracket.

[For illustration purposes, I am not even bringing state, city and certain withholding taxes or depreciation recapture into this example.]

The tax guy proceeds to tell Sal that he'd be crazy not to just sell and pay his taxes because the rates are currently so low that to defer them into the future- he will most likely be stuck in a higher tax bracket and pay much more in later years.

"Wow" says Sal, "That does sound like the best option. 5% is nothing really when all is said and done. Thanks, Mr. Tax Man, I think I will just sell and pay my taxes now."

That scenario does sound pretty good, right? You never thought Uncle Sam would be so generous. It is also a scenario I hear all the time as having been told to clients.

So, with that logic let's take it a step further. Let's just say I owned a million dollar building free and clear. I wanted to sell, but didn't want to pay 15% Federal Capital Gains Tax (150K). As a self-employed person I make 100K per year. If I stopped making income for a year, I'd be in the 0% tax bracket, so I'd only pay 5% Federal Taxes on that million dollar sale (50K). Effectively, I could take a year off, and still enjoy the 100K tax savings by doing so, and I wouldn't even have to pay income tax on that 100K! Yipee, I'm off to Tahiti!

OK, I'm trying to make a point here. Uncle Sam is not that generous or that gullible. This is not the way the capital gains tax calculation works, unfortunately. Sigh…

Let me show you how the federal calculation would go, reverting back to Sal's situation.

The first $7550.00 of Sal's income is taxed at 10%, the next $7450.00 is taxed at 15%. This makes up the 15K/year Sal earns as ordinary income.

Now his gain was 450K. The first $23,200.00 of that 450K gain is taxed at 5% capital gains rate. You see, although the gain is not ordinary income, it is considered towards Sal's gross income and sets his tax brackets. At $30,651.00 and above, Sal now enters into the 25% and above Federal Tax Bracket. So, the rest of the 450K gain ($426,800) is now taxed at the maximum long term capital gains rate of 15%.

So, instead of owing $22,500.00 (450K x 5%) to the feds, Sal will owe $65,180.00 to the feds ($23,200 x 5% plus $426,800 x 15%).

That's a difference of $42,680.00 and a heck of a shock if you weren't expecting it after you sell your property!

Don't get me wrong. There are a lot of good, qualified, capable professionals out there who do understand how capital gains tax is calculated. But I'm willing to bet for each one, there are another 3 who do not understand or simply misunderstand. They don't come across enough of the above type situations and give bad advice and counsel.

It comes back to the analogy that when you need brain surgery you don't go to a general practitioner to perform it. Find an experienced professional who handles this type of calculation on a regular basis. Get all of the facts before you make any decisions.

And, don't despair. The Capital Gains Tax strategies you do have available are still very powerful and are sanctioned by the IRS. They won't give away the farm, but they will help you plant crops for your future!

Remember, if it sounds too good to be true…that's right - it probably is.

Paula Straub