Weighing Long-Term Capital Gains Against Ordinary Income

August 6, 2013

Article by Glen Mather:

Why would anyone want to trade a 15% capital gain tax rate for a 22% marginal income tax rate?

During a recent presentation to a group of CPAs, I was asked this rather obvious question. We were in the process of discussing the relative merits of investing an IRA into rental housing.

For the investor that purchases with after tax money outside an IRA, certain tax advantages accrue largely based on the income and tax situation of the individual. If passive losses are able to offset ordinary income, an additional benefit can arise. However, the assumed disadvantage of the IRA investment in a similar real estate asset may not be accurate, based on the individual facts of the case.

Important variables to consider:

• The age of the investor
• The anticipated number of years until the investment will start to be distributed
• Estimated cash flow of earnings, if any
• Estimated profits upon sale of the asset
• How long each asset will be held
• How the proceeds from the sale of the investment will be re-invested
• The marginal tax rate of the investor at the time investment revenue is received
• The estimated marginal tax rate of the individual when the funds are to be distributed

Unless investments are in a fixed-return instrument, predicting investment results is a difficult task, and certainly forecasting individual tax rates in future periods is next to impossible. For the real estate investor using non-IRA funds, a 1031 exchange process may be a great choice if the timing of the sale and purchase permits. It will ensure that all of the proceeds of a sale can be rolled into the basis of the new property while forestalling capital gains until the sale of the final property.

The capital gain rates for those with federal marginal tax rates of 35% and 39.6% have been raised to 18.8% and 23.8% due to 2013 tax law changes and the affordable health care surcharge. Avoiding or deferring these higher charges for those in the upper brackets are now more necessary than ever for those outside IRAs. Indeed, these new LTCG brackets tilt the advantages more heavily to the benefit of using IRA monies for investments.

With an IRA, as long as the real estate investment is not leveraged, all gains are deferred until distribution, and then it’s taxed as ordinary income. Should tax rates stay constant (which they never do), generally the majority of retirees will enjoy a lower rate due to diminished earnings.

Roth IRAs change the landscape considerably. Roths are attractive for those who believe their investment performance will be able to recoup the tax costs of conversion or contribution, and for those willing to bet that future tax rates will be equal or higher in retirement than their current rates.

Glen Mather is President of NuView IRA, Inc., a leading self-directed IRA administrator in Orlando, Florida. He can be contacted at 407-367-3472 or gmather@nuviewira.com.