In our last five posts we have taken a hard look at several proposed changes to the federal tax code that we believe pose a significant threat to the commercial real estate market.
The new administration ran on a platform to eliminate 1031 exchanges, tax capital gains at ordinary income tax rates and do away with the step-up rule that allows heirs to establish a new basis at the fair market value of their inherited assets.
The current tax code is long-established and serves as a foundation for the investment strategies of both individual and institutional investors across the country. A change to any of the three would be disruptive, but in combination they pose a serious and significant threat to property values, market activity, debt levels and investor risk.
Posts You May Have Missed
- Is the Step-Up Rule In Jeopardy?
- The Impact of Taxing Capital Gains as Ordinary Income [Part 1]
- The Impact of Taxing Capital Gains as Ordinary Income [Part 2]
- Impact of Losing 1031 Exchange Rules
- Tax Times May Be A’Changin’ As New Administration Grabs the Reins
As we have made clear, our rather dire review of these proposals puts us at risk of appearing opportunistic, but we remain concerned enough to take that chance. What we mean to do here is warn rather than scare our existing and prospective clients. We do not know if or when the Biden administration intends to follow through on its campaign promises, but we believe it is prudent for you to take these potential changes seriously so you can analyze the threat for yourself and keep your real estate investment strategy in alignment with existing law and potential changes thereto.
Imagine for a moment that you have a highly appreciated industrial building that you have been considering selling in the next few years as part of your long-term strategy. Most likely, your plan would be to exchange your property for another one that offered you the opportunity to reposition your equity to greater advantage. Maybe you would buy a property in another market to capitalize on local market conditions. Or, perhaps you are an owner/user who has outgrown your current facility or need another property configured to help your business grow. By exchanging your property, you are able to put all of your equity into the new property, allowing you to take on less debt, buy a building of superior quality or in a better location to suit the needs of your business. All this can be accomplished without creating an immediate taxable event.
Now imagine having to pay capital gains taxes at ordinary income tax rates on your current property because the exchange rules have been eliminated. Under current law, you’ll give up roughly a third of your gain to state and federal taxes if you sell outright. Without the 1031 exchange rules and capital gains tax rates, your tax liability would likely be more than half of your entire gain. That is a massive increase that may discourage you from selling in the first place, as you would only have half as much equity to invest in the new property. If other investors like you make that same decision, transaction activity would decline over the long term, interrupting the flow of capital through the real estate market.
Since real estate is the last asset class eligible for 1031 exchange treatment, demand for real estate would also decline long term if exchanges were eliminated, as investors would be less inclined to take on the risk of acquiring illiquid assets like real estate without the 1031 advantage. Market activity is likely to slow over the long term as supply and demand fall together. Property values, which are driven by perceived risk, would decline along with market activity. We just can’t think of a good outcome to such a scenario.
If you have capital to invest, you evaluate the risks associated with the asset class you are considering, whether it stocks, bonds, mortgages, precious metals or commercial real estate. The higher the perceived risk, the higher the yield you should expect. Higher yield in real estate means higher cap rates, which lowers prices. A change in the market cap rate from 5% to 6% equates to a 20% decline in property value. The math is that simple and the threat is real if exchanges were eliminated and taxes on gains were at ordinary income tax rates.
Let’s take a look at a real-life scenario that is in the works right now. A client of ours owns a 6,000-square-foot building in Central Orange County, out of which he operates his precision machining business. Frustrated with the business climate here in California, he has been working on a plan to move to Arizona for the past several years. Until the beginning of this year, he expected to sell his building here and exchange it into a larger facility in the Phoenix area sometime in 2022. He already leases a small space in Phoenix to get the business established there before he moves the entire operation.
When we brought the possibility of the tax laws changing to exclude exchanges and capital gains tax rates, he responded to that threat by moving up the timeline of his plan. Knowing that he could capture a record price for his current property, he made his way to Phoenix and negotiated successfully to acquire a 12,000-square-foot building that would allow him to double the size of his operation. His current facility, which he owns free and clear, went under contract in a week at a premium price. By exchanging the entire proceeds into the Phoenix property (which he paid half the per-square-foot price for) he will have twice the amount of space, and his new mortgage payment on the small difference in the price of the properties will be just $2,000 per month or 16 cents per square foot. The entire process will be complete before any of the proposed tax hikes make their way into the headlines.
Does that sound like a pretty good outcome? We think so and so does our client. He simply executed his original plan, but pulled the trigger sooner in order to avoid the influence of the national debate on tax policy. Perhaps there is option out there for you that you haven’t fully considered because your current plan is to hold your property indefinitely. It will cost you nothing to find out, and it would be a prudent move given the level of threat these tax proposals present.
What about the step-up rule, the third element of the tax ‘trifecta’? Under current law, you can pass along your assets to your heirs when your days are over at a step-up in basis to fair market value as of the date of your death. Your heirs could then immediately sell the property at that price and keep the proceeds tax free. Thus the step-up rule is widely used in the estate planning world.
The Biden campaign ran on a platform to eliminate the step-up rule and give your basis to your heirs, which would result in a massive tax event whenever the inherited assets are sold. Obviously, this would be a broomstick in the spokes of estate plans everywhere, and could trigger a short term increase in the supply of property assets that would otherwise have been held until the time of death because the current swap ‘til you drop strategy would no longer be the useful tax-planning strategy that it is today.
Any disruption to the balance between supply and demand will impact property values. Our current supply shortage (along with the low cost of capital) is largely responsible for the meteoric rise in property values that has occurred since the last recession ended. Vacancy is at an all-time low as demand for property continues to rise.
While we believe supply and demand will decline over the long term if real estate loses favor with investors, just the threat of the tax hike trifecta is likely to increase supply in the short term, as property owners head for the exits. At the same time, many would-be buyers would move to the sidelines and wait to see how prices are impacted by the disruption before making their acquisitions. That means supply would increase and demand would decrease simultaneously, and that’s the stuff corrections are made of.
Once the dust settles, the real estate landscape may look substantially different than it does today. Without the ability to defer gains or sell with lower capital gains rates, property owners would hold their properties longer, fewer buildings would trade and business owners would be more inclined to lease for fear of being stuck with a building that no longer suits their operational needs. The illiquidity of real estate, already a drawback, would put investors large and small at even more risk.
None of the foregoing sounds very good to us, and we hope that once legislators study the potentially harmful effects of the tax trifecta, they will choose to pursue other priorities instead. Hopefully, they will realize that fewer transactions means fewer taxable events and less tax revenue rather than more.
We encourage you to give significant thought and allocate the energy needed to study your situation carefully to make sure you are ready to take action if it becomes necessary. Our goal is to help you make informed decisions and we stand ready to assist you in any way possible.