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.
