Under current federal income tax law, all taxable income from property sales must

be classified as either ordinary income, capital gain income, or depreciation recapture

income. The distinctions are important because capital gain income, under the tax rules in

place in 2006, is subject to a maximum 15 percent tax rate.2 In contrast, the maximum

statutory rate on ordinary income is 35 percent.

 Assuming the taxpayer's asset is classified as trade or business property and has

been held for more than one year, the total taxable gain on the sale of the replacement

property in year t+n has the following two components

 CG 2,s =(P -SC2) -UNDBASIS2,s (3)

and


 RECAP,2, = DEp2, (4),


where UNDBASIS,2, is the un-depreciated cost basis of the replacement property at time

t+n. More specifically, UNDBASIS 2 is equal to acquisition price of the replacement

property (P,2), plus any capital expenditures over the n-year holding period.3 Note that

the magnitude of UNDBASIS2, is conditioned upon whether the replacement property

was acquired via an exchange or with a sale-purchase strategy. Also note that CG2, is

the amount by which the original acquisition price of the replacement property (plus any

subsequent capital improvements) is expected to increase in nominal value over the n-



2 From 1997 to May 6, 2003, the maximum capital gain tax rate was 20 percent.

3 According to the IRS, a capital expenditure increases the market value of the property. In contrast,
expenditures deemed by the IRS to be "operating" expenses maintain, but do not fundamentally alter, the
market value of the property. Capital expenditures are not depreciable in the year in which they are
incurred. Rather, they are added to the tax basis of the property and then systematically expensed through
annual depreciation deductions.