How the New Tax Law Impacts Real Estate Investors

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Seasoned real estate investors are giving the “Jobs and Growth Tax Relief Reconciliation Act of 2003”, which was signed into law by President Bush in May of 2003, mixed reviews.



While the new tax package offers a much welcomed lowering of capital gain taxes and attractive incentives for investing in qualified improvements and certain types of equipment, it still leaves REIT dividends and depreciation recapture rates untouched. And, experts believe that, under the new tax law, more taxpayers will incur Alternative Minimum Tax liability, wiping out at least one-third of these taxpayers’ tax benefits. Despite the negatives, the tax package promises to boost investment in new property, cash flow and spending by real property owners.


Accelerated First-Year Depreciation Incentive


The acceleration of the first-year depreciation deduction should stimulate investors to improve existing properties and purchase certain types of equipment, such as security systems.


Under the new tax law, taxpayers are allowed to deduct an additional first-year depreciation equal to 50% of the adjusted basis of qualified property and depreciate the balance according to the current depreciation schedule. An apartment building owner who invests in qualified improvements will write off 51 percent in the first year. Since improvements are depreciated over 39 years, the 51 percent reflects the 50 percent of incentive depreciation plus 1/39th of the remaining balance.


In general, in order to qualify for the 50-percent additional depreciation deduction, investors must have acquired their property after May 5, 2003 and before January 1, 2005. Property does not qualify if there was a binding written contract for the acquisition in effect before May 6, 2003.


Property investors who claim 50-percent additional first-year depreciation deduction are not eligible for the 30-percent additional first-year depreciation deduction, which was added in 2001.


First-Year Bonus Depreciation Deduction for Real Property Improvements Under the New Tax Law


Reduction in Capital Gain Tax


The bill’s reduction in the capital gain tax will allow investors who dispose of real property to have more capital to reinvest in new property.


Investors who were paying a capital gain tax rate of 20 percent will now pay 15 percent. Investors who fall in the 10-percent and 15-percent ordinary income brackets will pay a capital gain rate of 5-percent through December 31, 2007 and will have their rates reduced to zero in 2008. The tax law’s new lower capital gain rates apply to both the regular tax and the Alternative Minimum Tax.


The provision applies to sales and exchanges (and payments received) on or after May 6, 2003 through December 31, 2008.


Rise in Number of Taxpayers Incurring Alternative Minimum Tax Liability


An overlooked negative result of the bill is that more taxpayers will fall under the deadly Alternative Minimum Tax. While Congress has lowered the tax rates, it has maintained the brackets for the Alternative Minimum Tax. The result? The Alternative Minimum Tax will apply to an estimated 33 million taxpayers by 2010, according to the Urban-Brookings Tax Policy Center. These taxpayers’ new tax status will decrease their tax benefits by at least one-third. Those earning from $100,000 to $500,000 will suffer the most as will numerous industries, including the refi, remodeling and vacation home markets. Taxpayers incurring Alternative Minimum Tax liability are denied most deductions, including those for real estate taxes, state income taxes, home-equity interest and state capital gain taxes. Interest on primary residences and charitable contributions are the only allowable deductions. A portion of these taxpayers can apply an exemption to their Alternative Minimum Tax liability. The Alternative Minimum Tax exemption is phased out beginning with income over $150,000 and ending completely for taxpayers earning $382,000.


The new law has increased Alternative Minimum Tax exemptions to $58,000 for married taxpayers filing jointly and surviving spouses and $40,250 for unmarried taxpayers. However, taxpayers who experience a large capital gain may boost their income beyond the Alternative Minimum Tax exemption, reducing the effectiveness of the decreased capital gain rate. The increase in the Alternative Minimum Tax exemption is effective for taxable years 2003 and 2004.


Depreciation Recapture Rate Holds at 25 Percent


The reduction in capital gain tax does not have as dramatic an impact for real estate investors as it does for investors in stock. Many investors who sell real property will still face a hefty tax bill under the new tax law. The reason? The tax package has not provided for a lowering of the 25-percent tax owed on depreciation recapture. When calculating the total tax due in a disposition of real property, the depreciation recapture tax is first applied to the investor’s tax liability with any remaining tax liability taxed at the capital gain rate (provided the investor has held the property for one year or longer).


Mixed Reviews for REITs


Investors in Real Estate Investment Trusts (REITs) face mixed blessings. Sellers of shares of REITs will benefit from the lower capital gain tax rate. Taxes on REIT dividends will continue to be taxed at ordinary income rates because REITs generally do not pay corporate taxes. REITs, which are publicly traded real estate companies that invest in commercial properties, are exempt from paying taxes since they pay out at least 90% of their taxable income in dividends.


As a result of the new tax law, investors in REITs may face an uncertain future. Investors may begin to view non-REIT securities as a better investment and start flocking to securities in which yields are taxed at a lower rate.


REITs have historically been attractive to investors seeking dividend-yielding investments. Over the past three years, REITs’ average performance has surpassed that of the Standard & Poor’s 500-stock index. As of May 23, REITS’ average yield was about 7%, compared with about 2% for the Standard & Poor’s 500-stock index, according to Morgan Stanley.


The National Association of REITs continues to be upbeat about REITs’ future, citing that the after-tax average dividend generated by REITs under the new tax law would be approximately three times that of the Standard & Poor’s 500-stock index.


Business Incentives-Increase in Section 179 Expensing


The new tax law allows small businesses to increase their deductions for expenses under IRC Section 179 from $25,000 to $100,000. This provision applies to property placed in effect in taxable years beginning in 2003 through 2005. Businesses that qualify for this investment begin to phase out with investments in excess of up to $400,000 (increased from $200,000). These amounts are indexed annually for inflation, beginning in taxable year 2004. Off-the-shelf computer software placed in service for a taxable year beginning in 2003 through 2005 qualifies for this deduction.

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