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Capital gains tax increase impacts commercial real estate.

The Bush tax cuts set to expire on December 31, 2010, directly affecting how capital gains taxes will be taxed going forward. Taxes will revert to 20 percent from their 70-plus-year low of 15 percent.

The tax rate on dividends will jump from 15 percent to 39.6 percent for the highest earners. Consequently, many investors will likely lock in their profits rather than wait for investments to appreciate sufficiently to offset the 5-percent tax hike.

Apartment rentals will post good gains in major real estate markets in the coming year. However, the commercial real estate market will continue to experience weakness in 2011, encouraging owners to retain their properties.

For investors holding these assets, future capital gains tax increase, could affect future appreciation. On the other hand, investors who purchased these assets years ago may likely want to liquidate this year to avoid capital gains increases.

As a consequence of the upcoming increase in capital gains taxes, commercial real estate investors may seek to defer them through 1031 exchanges.

The number of deals involving 1031 exchanges have waned in the past year, but as capital gains taxes rise, the percentage of deals is expected to increases, and sellers will be further discouraged from taking profits from the investment real estate sector.

This will result in a future slowdown in the commercial real estate market.

The tax increase on real estate partnerships, which own most of the commercial buildings in many U.S. markets, could have the most immediate impact.

By reducing the after-tax gain that a potential buyer expect to realize, the tax increase will further hinder straggling market.

According to many investors commercial real estate activity generally remained weak, and the elevated inventory of existing properties for sale or rent continued to weigh on new construction.

But valuations are key to avoid a replay of the residential debacle in commercial property. Over the next five years, more than $1.5 trillion in commercial real estate debt will be falling due.

Without the subsidies poured into the residential market, many managers of commercial properties have aggressively responded to the downturn by raising capital or buying back or restricting their debt.

The likelihood of the increase in capital gains taxes has prompted debate along party lines as to how best raise revenue. Some in congress want to extend the capital gains tax cut for all income brackets, and others want certain brackets to pay more and some to remain the same. The increase in capital gains taxes will stoke activity in the 1031 tax exchange market, as participants look to take advantage of deferring capital gains and associated taxes through tax-deferred exchanges.

Apartment owners will see gains next year, offsetting some of the capital gains increases. However, commercial real estate will remain in the doldrums.

This will encourage investors to keep this class of assets for a longer period or, conversely, sell this year to realize profits at low capital gains rates.

Presently, we have seen an increase in activity on the sell side in order to lock in capital gains rates for this year.

The tax increase will definitely hurt the sale of those properties that have been held for long term, since their capital gain is substantial. These landlords are usually private investors who are often not interested in reinvesting the proceeds of the sale in a different piece of property but rather in cashing out and distributing the proceeds to family members.

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For investors who retain these assets, future capital gains tax increase will factor into their decisions of when to sell them, causing less supply, which would raise demand.

But as real estate advisors, we know that to understand and explain the whole picture to our clients we need to put everything in perspective and look at capital gain taxes in the United States form a historical point of view.

Considering long-term capital gains taxes have averaged 26 percent over the last 50 years, even hitting 40 percent in 1976 during the Nixon/ Ford administrations, risk of further increases once the economy stabilized 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 in 2011.

BY MOSES SIONI

MANAGING DIRECTOR

SIONI AND PARTNERS
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Comment:Capital gains tax increase impacts commercial real estate.
Author:Sioni, Moses
Publication:Real Estate Weekly
Date:Nov 3, 2010
Words:717
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