Unraveling the capital gains tax Featured

8:00pm EDT September 1, 2010

john leonard, first vice president and regional manager, atlanta office, marcus & millichap real estate investment services

Smart Business spoke to John Leonard, first vice president and regional manager of the Atlanta office of Marcus & Millichap Real Estate Investment Services, about the impact of new tax developments on businesses and investors, and the state of the economic recovery through early 2011.  

The Bush tax cuts are set to expire on Dec. 31, 2010. The planned expiration of the capital gains tax has made headlines recently. Why is the capital gains tax issue important to real estate investors?  

The expiration of the tax cuts means capital gains taxes will revert to 20 percent from their 70-plus-year low of 15 percent. Also, barring legislative intervention, the tax rate on dividends will jump from 15 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 that 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, risk of further increases once the economy stabilizes remains 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.

 

What proactive measures are commercial real estate investors implementing in response to the expected tax hikes? 

 

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.

 

Will the expiration of the Bush tax cuts, combined with the recent expiration of the Obama administration’s housing tax credit, place additional pressure on the fragile economic recovery?   

The economic recovery will continue to make slow, choppy progress through the remainder of 2010 and into early 2011. While risks such as another slide in the housing market and slipping business/consumer confidence persist, a double-dip recession remains unlikely. Still, several forces will drag on growth in the near term, hampering the pace of recovery. To start, the consumer sector, which accounts for 70 percent of U.S. GDP, will remain strapped by tight credit conditions and high unemployment over the next several quarters. In addition, the extended downturn has driven a shift in consumer psychology, leading households to pay down debt and increase savings as opposed to spending disposable income on goods and services. This places the onus of transitioning the recovery into a self-perpetuating expansion cycle on businesses, which first need to regain sufficient confidence to initiate more substantive hiring and capital spending.

 

What is the private sector’s role in the economic recovery? 

 

While corporate profits have soared in recent quarters, large companies have amassed record-high levels of cash, reducing their reliance on credit markets to fuel growth but also hampering the pace of the economic recovery. Small businesses, which account for nearly half of all private-sector employment, face greater challenges at this stage of the cycle and will drag on the recovery. Lacking significant cash stockpiles, small businesses continue to encounter difficulties securing credit for expansion, despite modest loosening in lending conditions recently.

Which sector or sectors of the real estate investment market are performing well? 

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. Very modest private-sector job growth and stronger household formation released some of the pent-up renter demand accumulated through the downturn. Improvements were broad-based, with 70 percent of all major U.S. apartment markets recording occupancy gains. As 2010 progresses, more pent-up demand for apartments will be released, particularly among the estimated 2.2 million young adults who have moved back with their parents since 2005. The outlook brightens considerably for 2011 and beyond amid expectations for improved economic growth, powerful demographic shifts supporting a surge in renter demand and limited new construction. These trends will likely result in a shortage of apartments nationwide, driving rent growth to above-average levels by 2012 or 2013.

Which property sectors are struggling? 

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.

 

Joh n M. Leonard is a first vice president and regional manager of the Atlanta office of Marcus & Millichap Real Estate Investment Services. Contact him at john.leonard@marcusmillichap.com or (678) 808-2700.