Feds drop capital gains tax.

The real estate industry is applauding Congress for passing a budget bill that contains promised reductions in capital gains taxes, contains other provisions affecting real estate investment trusts and provides for brownfield clean-up tax incentives in targeted empowerment zones.

The bill drops the top long-term capital gains rate from 28 percent to 20 percent, and reduces it to 10 percent for those in the lowest 15 percent tax bracket, but includes a depreciation recapture provision taxing any depreciation at 25 percent.

Tax exclusions for the sale of a primary home will also be increased from $125,000 to $250,000 for singles and to $500,000 for couples, and is expected to fuel the residential markets as older homeowners change habitats and cash-in on their home's appreciation.

President Bill Clinton is expected to sign the measure this week that includes other detailed real estate provisions, including some that don't kick in until 2001.

Buyers and sellers should consult with tax counsel before making any investment decisions to ensure the new bill language conforms to their investment strategy.

While the real estate industry was primarily positive in its reaction, there was grumbling about the depreciation recapture provisions. There was also a sense of "so what?" from those investors who believe if they sell long-term holdings, they will have to pay more for any new investment properties.

Still, the overall reaction was positive.

"It's clearly an improvement over the current system," said Steven Spinola, president of the Real Estate Board of New York (REBNY). "We are not happy that real estate is being treated differently [with the depreciation recapture], but we think it will help move transactions in the market." Every time they change a tax law, Spinola noted, "there will people who will benefit, and those who will get hurt."

The Washington-based National Multi-Housing Council has been keeping an eye on the various permutations of these provisions for some years. Its Vice President, James Arbury, says the apartment industry is also disappointed in the depreciation recapture rate, but called the final overall tax bill "a very big plus for our industry and for renters."

Arbury says the measure provides more disposable income for many Americans, who will be able to use it to invest as well as to pay bills.

"The thing they did at the last minute in terms of extending the holding period for 18 months takes away the sting of the 25 percent recapture and competing for investment dollars," Arbury added.

Steven A Wechsler, president of the National Association of Real Estate Investment Trusts (NAREIT), says they are pleased with the rule changes that are being made for REITs. "They will lead to greater efficiencies and competitiveness for REITs," he said. Some of the more technical changes not mentioned in this article are among the 80 line items that President Clinton could veto, but Wechsler says they have no reason to believe any of the REIT provisions will be eliminated.

Tax attorney Lary S. Wolf, a partner with Roberts Holland, explained the depreciation recapture. "If I bought property five years ago for $100 and took $30 for depreciation, and then sell the property for $110, my gain would be $40," he said. To figure that out, you take the $100 original price and subtract $30 for depreciation which comes out to $70, and then subtract that from $110 to come out with the $40 gain.

"The depreciation reduces the basis in the original cost," he said. "The new law's depreciation recapture provision says to the extent I took depreciation ($30), I pay taxes at 25 percent. The gain over my original cost ($10) would be taxed at 20 percent."

Wolf said under the old tax laws, to the extent an owner took straight line depreciation on their real estate, all of the gain was taxed at the favorable capital gains tax rate which was 28 percent.

"The new law changes that so the depreciation is taxed at 25 percent and the real gain at 20 percent," Wolf said. "This isn't a perfect world and people were hopeful the depreciation recapture would not be included, but it is clearly an overall lowering of the tax burden when you sell real estate."

While the 25 percent recapture rate places real estate at a disadvantage to other investments, Arbury believes the extension of the holding period for all long-term capital gains from the current 12 months to 18 months will help even out the investment field, as it won't really affect real estate because it is typically held for longer periods than other investments.

Need 18-Month Holding

According to information provided by the National Realty Committee because of earlier announcements, sellers that completed transactions between May 7 and July 29 can benefit from the lower gains tax even if they only held the property for 12 months. But any transactions dated after that owned for more than 12 months but less than 18 months would continue to be taxed at the 28 percent rate.

Investment sales broker William M. Shanahan, a senior director with Cushman & Wakefield, thinks the new gains tax structure will propel relatively recent suburban office buyers to put properties on the market.

These are investors who bought portfolios in the early 1990's at low prices from the Resolution Trust Corporation (RTC) and other institutions, and have now upgraded and turned around the asset.

"There was a real frenzy of buying in some of the suburbs and they have built up a real gain from the RTC portfolios," Shanahan explained. "For a lot of those investors, the strategy was to be in and out. They were not intended to be long-term owners."

Additionally, Shanahan quipped, "half of Downtown is ready to do a flip" as those early contrarian buyers see quick gains available now that office space is filling up and the 24/7 residential community is awakening.

Kevin Haggarty, executive managing director of Insignia Capital Finance Advisors who works nationally in Atlanta, Chicago, Los Angeles, New York and by the end of the year in Dallas, San Francisco and Washington DC, says the new rules will "add more fuel to the fire."

"If you look at the impact of the repeal of the [10 percent New York State imposed] Cuomo Tax, and now you will drop another 8 percent, it will add to the impetus to sell," he predicted. "You probably have a number of holders anticipating there would be a change in the capital gains rates and now, the new rules will give an impetus to those who want to move on and re-invest."

Housing Tax Credits Continued

Dan Marguiles, executive director of the Community Housing Improvement Program (CHIP), a middle market owner's group, thinks the overall tax package will be helpful.

He noted that Congress also continued the low income housing tax credits that were in danger of sunsetting and will encourage investment, while the tax structure for those with lower incomes will make it easier for them to pay rent.

One critical item for those owners who expected the capital gains tax to be lowered and already structured sales based on installment payments, Arbury says, is that any payment received after May 7, 1997 will be taxed at the new capital gains rate.

"So if you sold two or three years ago on an installment basis, if x percent is a gain, you pay the tax at the new lower rate as long as you received the payment after May 7," advised Arbury.

Five-Year Provision

In order to encourage long-term investment, the law also makes a new provision to reduce the capital gains taxes for those that hold real estate for five years.

Beginning January 1, 2001, if the property is held for five years, the new 20 percent and 10 percent structure will be reduced to 18 percent and 8 percent, respectively.

To begin the five-year holding period at that time, top bracket owners can "mark to market" by paying the taxes as if they were selling on that date.

"So in 2006 you get the 18 percent capital gains rate," said Arbury, who was not worried about any future changes in the tax laws. "If they are going to change the tax law, they will change it before 2001, but if not, they would grandfather people," he predicted.

City investors also see the drop in taxes affecting investment strategies. John A. Werwaiss, a principal with Werwaiss & Company, says he thinks the drop in taxes will have an impact on a seller's attitude because there will be less in taxes to pay, but it won't make an impact on a buyer's willingness to pay more for a property.

"I don't think you will pay more because the alternative to investing in real estate would be investing in stocks, so it makes investing in any kind of asset more attractive," he explained. "I also don't think the seller will want more, but he is more likely to sell because he has less of a tax to pay. It would certainly make any offer of sale more attractive because we will have 8 cents more left on a dollar to re-invest."

Still, Werwaiss noted, "The lower tax doesn't make the return better going in, and if the price goes up, it will in fact make the return lower."

Stephen Barkin, another real estate investor/manager, is one of the few contrarians who believes the lower tax will make essentially no net difference.

"Even if you save on taxes, you will not be able to replace what you've sold," he said. "You will pay so much more for what you buy, so whatever the tax savings you might gain, you will give back by paying a higher price for the next deal. New York is a hot market."

But as a real estate investor, Barkin doesn't think selling his properties and investing in the financial markets is something he wants to take a chance on.

"You can get a very low return on Treasury bills or put the money into a common stock mutual fund, but you might be subject to a market depreciation. I'd rather have my money."

Residential Rules

The primary home residential sales market is expected to be strongly ignited by the increase in the one-time tax exclusion, doubling it for singles to $250,000 and quadrupling it to $500,000 for couples filing joint returns.

According to information released by Finance Committee Chairman Senator William V. Roth, Jr., taxpayers generally must own and use the home as a principal residence for an aggregate of at least two of five years prior to the sale. Sales of a remainder interest are eligible for the exclusion.

This exclusion applies to sales on or after May 7, 1997 and may be taken once every two years, according to the NRC. Additionally, says the New York State Association of Realtors, the homeowner no longer has to be 55 years of age to take this exclusion.

But the owner will not be able to rollover any gain beyond $500,000 to a more expensive home, Arbury says.

"The biggest thing is that it will free up people who move around the country who no longer have to keep buying but can now rent," he said.

Still, it is expected to open a whole new world to retirees in expensive homes who can sell and retire to more modest digs. In suburban areas of the country like San Francisco and New York, where home prices have risen quickly, a whole new breed of yuppie home flippers could arise, similar to what occurred in New York City when renters bought cooperative apartments at insider prices and quickly sold them, buying bigger and more expensive pads.

Susan Greenberg, a sales agent with Julia B. Fee's Scarsdale office, says people who have been waiting for the Federal action will now sell their big houses and have an opportunity to move to many other locations and living situations.

"Those people have to have somewhere to go," she noted. "The new clusters of housing will benefit if they have a master [bedroom] on the main floor - this is what everyone has been asking for - and the local co-op market will benefit as we see a turnover of larger units. Nationally, you will see vacation locations like Florida and other warm climate areas benefit, as well the active and assisted-living retirement communities."

City broker Eleanor Silben, who has been waiting for tax reductions to sell an East Hampton investment property, is very excited about the new provisions. "Everybody was thinking of 28 percent, and now it's 20. That 8 percent is huge."

Federal real estate tax changes

What's In

* If an asset is held 18 months or more, the top tax rate on gains is 20 percent while the lowest rate is 10 percent.

* Depreciation recapture provisions will tax straight line depreciation at 25 percent.

* Symetric Alternative Minimum Tax treatment.

* Assets sold after May 6, 1997 and before July 29, 1997 and held for at least one year and a day can obtain the lower 20 percent or 10 percent gains tax rate.

* Homeowners can take these exclusion/exemptions on the gains of their primary residence no matter what their age. For primary homes, single filers who sell after May 7, 1997 exclude $250,000 while joint filers can exclude $500,000. The residence had to have been lived in for an aggregate of 2 years out of the last 5 years. This exclusion can be taken only once every two years.

* Low income tax credits are continued.

* Taxpayers can deduct the costs of moderately contaminated brown fields in targeted empowerment zones.

* Establishes a diminimus exception for REITs so they can provide previously unacceptable services [like wheelchairs in shopping malls].

* Retains corporate tax deduction for interest on debit used to purchase industrial development and mortgage revenue bonds.

What's Out

* Repeals the REIT 30 percent gross income test that required no more than 30 percent of REIT income to come from the sale of recently acquired properties (stocks and securities held for less than one year), "dealer" property and real property held for less than four years.

* Eliminates double taxation on REIT capital gains by providing shareholders with credit for cap gains taxes paid at the corporate level.

* No new liquidation tax on C corporations that convert to S corps. or merge with REITs.

* No inflation adjustment for gains.

* No reduction in corporate capital gains taxes.

* No new taxes on exchanges.

* No longer have to be 55 to exclude gains on home sales.