Last week we began our discussion on the new administration’s stated objective to tax long term capital gains at ordinary income tax rates. That would take the tax on those gains to 37% from the current 20%.
The administration also ran on a platform to raise that 37% maximum to 39.6%. If both proposals became law, the federal tax rate for capital gains would go up to 43.4% after adding the 3.8% Obamacare tax on investment income. After adding California state income tax of up to 13.3%, the total tax on a capital gain would exceed 50%. So far, there’s been no word on how federal depreciation recapture tax would be treated. That rate currently stands at 25%.
Today we look at the impact of these potential changes on the commercial real estate market.
First, we believe that transaction velocity would decline, as even more investors would decide to hold their properties longer to delay such a significant taxable event. High transaction velocity makes market direction easier to read and promotes investor confidence to remain active.
Second, investors entering the market as buyers would be faced with the prospect of holding their properties for a longer term for the same reason. That could reduce demand from owner/user buyers who may need to dispose of assets to accommodate future business growth.
Third, slower market demand would decrease liquidity as reduced transaction velocity would increase time-on-market for assets that do become available. This would be problematic for those who need to sell quickly, especially owner/users who need to acquire alternate property to accommodate changes in their operational needs. Lack of liquidity is already one of the bigger risks in owning real estate, as opposed to stocks and bonds, which can be sold instantly rather than in a matter of months. So, anything that decreases liquidity would be detrimental to all types of commercial real estate.
Fourth, the foregoing, in combination, increases the risk associated with owning real estate. When risk goes up, investors will demand more yield to accommodate that risk. That means cap rates would rise, resulting in lower prices for commercial property assets.
Fifth, the profile of commercial property ownership would likely become more institutional. Big institutions tend to look longer term in their underwriting of potential acquisitions. They buy property for long term cash flow and are equipped with in-house property and asset management functions, giving them an advantage over small private investors. Having a higher concentration of institutional owners would likely lead to a rise in lease rates, as more businesses will be forced to lease rather than buy their own facilities.
The actual impact on market conditions over time will be influenced by all of the foregoing to varying degrees. So, it is impossible to accurately predict long term market implications. However, it is safe to say that higher taxes will influence decision making and reset expectations for real estate ownership.
Next week, we will take a look at another of the administration’s proposals: eliminating the step-up rule. Stay tuned.