We have published several posts on the topic of capital gains taxes over the last several years. It’s not that we actually like to talk about paying taxes. We don’t. Yet, the issue is front and center in every conversation we have with a client who is evaluating his or her property disposition strategy.
That is as it should be.
The tax consequences of selling a highly appreciated industrial building are substantial and, once calculated, tend to evoke a variety of emotional responses accompanied by some rather colorful language.
Sometimes the number is substantial enough to be the only reason an owner won’t sell, even if they would prefer to redeploy their equity into other aspects of their lives. They simply refuse to put themselves in a position to part with that much of their hard-earned equity. In doing so, they tend to overlook the potential increase in risk associated with holding their property for an indefinite period just to avoid paying taxes.
Those who do decide to sell, often choose to exchange their properties to defer the dreaded tax event. But by employing that strategy, they have only modified their risk profile and position to the extent that the relinquished property is different from the acquired one. The risk of ownership is still in play. The old saying: don’t let the tail wag the dog comes to mind.
Understanding all possible ramifications to selling commercial real estate is critical to making the most informed decisions. Tax liability is a big one, but not the only one. Building efficiency, current market value, economic trends, debt level, vacancy, maintenance cost, functional obsolescence, portfolio diversification, age & health of the owner and a variety of other considerations should also figure into a balanced disposition strategy. But, the one that trumps them all is tax liability.
When we ask our clients if they would sell their highly appreciated industrial property if they didn’t have to pay state and federal taxes, the answer is usually yes. Then they go on to tell us all the great things they would do with their profits: retire, buy a second home, put the grandkids through college, buy a bigger boat, travel around the world, etc. The list goes on, but the point is that most of the owners we talk to would choose to use the money to improve the quality of their lives, but they refuse to spend part of it on taxes to create those opportunities.
Instead, they have adopted an open-ended exit strategy hoping that nothing bad happens that could reduce the value of their assets. Put bluntly, that works fine until it doesn’t, and things can change overnight, something that has recently been made clear to us all.
These days most properties fall into the category of highly appreciated because we have just enjoyed the longest bull market for commercial real estate in US history. Building owners have seen their property values more than double in less than ten years, and values appear to be holding despite the current economic crisis. That means the opportunity to exit their investments with a windfall profit is still there, even after writing those big checks to the IRS and Franchise Tax Board.
Just how much would you pay in taxes if you sold your property?
The formula is simple and takes just a few minutes to calculate. If you would like to know what your tax bill would be if you sold your property, we just need a few simple pieces of information to give you an approximate number. Most likely you will pay just under a third of your gain in taxes, and more importantly, you’ll keep the other two-thirds to do whatever you want with.
So, the glass is two-thirds full, and more than a few property owners are coming around to the idea that capital gains taxes are the price paid for mitigating risk.
In essence, the tax liability could be perceived as a hedge against a market correction, and hedging is a prudent and time-tested strategy for investors at all levels. Is it possible that you are allowing the tail to wag the dog? We think that’s a question worth a conversation. Just give us a call if you agree. We are here to help.