What You Keep vs. What You Pay

Making the decision to sell a highly appreciated asset is not an easy one. The very thought of writing huge checks to the IRS and the Franchise Tax Board is enough for most property owners to dismiss the idea of cashing out.

Some opt for a hold-forever approach instead, while others exchange into other real estate assets to upgrade their portfolios and defer taxable events. Both those options have their place depending on individual circumstances, estate planning strategy and life circumstances.

However, planning a real estate strategy around an aversion to taxation has potential drawbacks. Values in every asset class run in cycles as numerous economic forces move pricing higher or lower. Individual investors have no control over macro-economic metrics, only their response to them. Some sell before a perceived market peak to assure themselves of a tidy profit. Others hold on too long in hopes of maximizing profits, and find themselves chasing the market in the wrong direction and selling during a correction. 

The truth is that nearly all real estate dispositions made today have significant tax consequences given the rapid rise in property values over the past 10 years. The IRS first imposes a 25% recapture tax on depreciation taken during the hold period. Then, it adds federal capital gains taxes of 20% and the 3.8% net investment income tax. The California Franchise Tax Board will then take its cut of up to 13.3% of the entire gain. Usually, this nets out to a tax burden of approximately 35% to 36% of the overall gain. So, it becomes easy to see why so many investors have made the tax-driven decision to hold their assets. 

But, right now there are a lot of Orange County industrial property owners wringing their hands over what to do. On the one hand they see property values continue to rise, but on the other they grow increasingly concerned over proposed changes to the tax code that would increase the overall tax on a capital gain to nearly 57%, including California state tax. Besides the additional tax burden, the impact on future property values could be substantial. Those prone to brinksmanship are holding on in the hope that taxes don’t go up, while others with a more critical eye on capital preservation are deciding to sell before they do. 

To assess your own situation it might be helpful to think in terms of what you will keep rather than what you will pay if you sell. 

With that in mind, here’s another way to look at the tax issue. In the last several years, industrial property values have been rising at a double-digit annualized pace. As a result, if you sold your property outright under current market conditions, most or all of the federal and state taxes due would probably be covered by just the last two year’s increase in your property’s value. The rest would be yours to enjoy. Put yet another way, it’s the same as having sold your property two years ago at a then-record price without paying any tax at all. For tax averse property owners, that would have been an easy decision. They would have sold in a heartbeat. What would you have done under those circumstances? Your answer to that question is important enough to give it some serious thought.

If you’d like to see a financial model of the benefits and consequences of selling your property, we can help. Just give us a call.