Capital Gains Tax Set to Rise at Year End; Transaction Activity May Edge Higher as Long-Term Owners Lock in Profits

August 15, 2010

  • With the Bush tax cuts set to expire on December 31, 2010, capital gains taxes will revert to 20 percent from their 70-plus-year low of 15 percent. In addition, barring legislative intervention, the tax rate on dividends will jump from 15.0 percent to 39.6 percent for top earners. When substantial tax code changes took effect in 1986, including a capital gains rate increase from 20 percent to 28 percent, investor liquidations nearly doubled the total realized capital gains from the previous year. Despite the decline in investment values over the last two years, many investors will likely follow this liquidation strategy, locking in their profits rather than waiting for investments to appreciate sufficiently to offset the 5 percent tax hike.
  • Recent commentary by Treasury Secretary Geithner suggests the Obama administration will allow the Bush tax cuts to expire. The reluctance to endorse even greater rate hikes likely stems from concern more significant increases could further impede the economic recovery. Considering long-term capital gains taxes have averaged 26 percent over the last fifty years, even hitting 40 percent in 1976 during the Nixon/Ford administrations, risk of further increases once the economy stabilizes remain high. As a result, though investors often choose to hold assets in the year following a rate hike, perceived tax-related risks may encourage them to continue selling assets in 2011.
  • Apartments have taken the lead in the national recovery and will likely post notable occupancy and rent gains in major markets over the next year. Demand for retail and office space remains tepid, however, particularly in secondary and tertiary markets, placing downward pressure on rents and preventing owners from regaining substantive pricing power. For investors holding these assets, future capital gains tax increases could overshadow appreciation substantially, extending the hold period to break even against current net profits for several years. Investors who purchased these assets more than six years ago likely have profits to protect and may consider liquidating late this year.
  • In response to the increase in capital gains taxes, commercial real estate investors’ ability to defer capital gains indefinitely through 1031 exchanges will become even more attractive. Since 2002, the year before the capital gains tax rate was reduced to a 70-plus-year low, the number of 1031 exchanges has fallen by nearly half. As capital gains taxes rise, the share of deals involving 1031 exchanges will increase substantially, as sellers will be further discouraged from taking profits from the investment real estate sector.

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The information contained herein was obtained from sources deemed reliable. Every effort was made to obtain complete and accurate information; however, no representation, warranty or guarantee to the accuracy, express or implied, is made.

10 Comments

  1. Neil
    Posted August 26, 2010 at 6:37 pm | Permalink | Reply

    On the surface, the idea that the increase in capital gains tax will spur an increase in sales velocity may seem valid. But if whoever did this research was actually in the trenches for commercial real estate, they would have noticed that this “basic formula research” will not apply here. Specifically, owners with quality assets are not going to put their property on the market to sell at CAP rates that are now 100 to 200 basis points higher than a few years ago. Simple math suggest that an investor with $1 million in capital gains stands to pay an additional $50,000 from the capital gains increase. However, an investor with a property that puts out a $250,000 NOI, which is what you would basically need to have an asset with at least $1 million in equity, stands to gain around $390,000 if that investor waits to sell his asset at a 7.5 CAP instead of at a 8.5 CAP which is what today’s rates are at. And I’m sure as the numbers are thrown around from CAP Rate to CAP rate, that the gain of waiting to sell for improved CAP rates far out weighs any potential extra taxation. Plus, finding a quality up-leg is difficult today, not to mention getting appropriate funding for that up-leg is even more difficult. It’s disappointing to see such a simplistic headline and report on something that is formula based without any true insight as to what is really going on in the market place. As a client of M&M who recently purchased a property in Phoenix, I hope this type of research can provide more detail and that M&M can step out away from what everybody else says and really hit home with the invesotrs that need quality research in these tough and strange times. Thank you.

  2. Phil
    Posted August 26, 2010 at 10:03 pm | Permalink | Reply

    @Neil: You base your point on a couple of assumptions that may not hold water
    1) that Cap Rates will decline by 1%
    2) that the investor plans to hold for long enough to recover
    3) that cap gains taxes won’t push past 20% in coming years

    I think the point of the blog is that some investors may not want to take that risk… who knows how much the capital gains tax will increase over the next few years- they have been as high as 40% in the past and based on current gov’t deficits, they could push past 20% in coming years.

    Incidentally… if the investor is taking his chips off the table and paying out the taxes, an upleg isn’t relevant since they won’t 1031 (hence the tax hit).

  3. Posted October 1, 2010 at 12:49 am | Permalink | Reply

    Valid points, but I think we’re forgetting that commercial as well as residential real estate have generally been long term investments (and require a certain amount of holding power; which should allow you to shirk the short term change in tax codes).

    Not to mention the fact that the markets, as well as the tax codes run in cycles of 10-20 years. Thus, we need to look at this from a macro perspective.

    Unfortunately those who are looking to exit the market (in the next few years) are going to be in a difficult position.

    On the other hand those entering the market (or shift assets via a 1031 exchange) will be reaping the benefits of a slumped market…it a great time to invest; however certainly not an ideal time to divest.

    This seems like the perfect time to capitalize on the 1031 exchange. Shifting your assets may result in a loss on the sale, however if done properly you should be able to locate a purchase option that will offset your loss, and likely put you ahead of the game.

    Tax code change or no tax code change; I think it’s time to get creative and look for a way to use this down turned market to our advantage.

  4. Posted November 17, 2010 at 3:42 pm | Permalink | Reply

    I haven’t noticed any decrease in the money the commercial renters are asking for. This is in southern NJ.

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