Christopher Nolan’s family has owned three rent-stabilized apartment buildings in Astoria, New York, for almost 80 years. He wants to sell them by the end of 2010.
The decision to market the 220-unit complex was prompted, in part, by Congressional deadlock over renewing Bush-era tax cuts. An end to the reductions, set to expire Dec. 31, would result in Nolan paying higher taxes on profits from a property sale if he makes a deal after this year.
“Capital gains is definitely one of the major factors,” said Nolan, who owns a stake in the Astoria buildings in the New York City borough of Queens. “It makes it more attractive to sell in 2010 than otherwise.”
Longtime U.S. property owners such as Nolan are testing the sales market amid uncertainty over the status of the tax cuts, setting the stage for a surge in transactions followed by a decline, said Robert Knakal, chairman of Massey Knakal Realty Services, a brokerage in New York. His firm has already seen a jump in deals, with contract signings reaching the highest monthly totals in three years each month since July.
“This is just like ‘cash for clunkers’ or the first-time homebuyers’ tax credit,” said Knakal, referring to the government incentives for automobile and housing sales that led to a temporary jump in demand. “It’s essentially going to steal activity from the beginning of next year to the end of this year.”
President Barack Obama has proposed ending the tax cuts enacted during the presidency of George W. Bush for families making more than $250,000 annually and raising levies on capital gains, which include real estate profits, to 20 percent from 15 percent for those same earners. Republicans want to make the reductions permanent for all Americans. Congress adjourned in September without settling the issue and will resume the debate when it returns for a session starting Nov. 15.
The Obama administration is “open” to negotiations on temporarily extending tax cuts for upper-income individuals to win extensions for middle-income families, White House press secretary Robert Gibbs said Nov. 4, two days after mid-term elections made Republicans the majority in the House of Representatives. The lawmakers elected Nov. 2 take office in January, after the lame-duck session this month.
“The interesting question is what do these outgoing Democrats do?” said Gerald Prante, an economist at the Tax Foundation, a Washington-based research group that advocates lower taxes. “Do they care?”
Commercial-property sales soared before the implementation of a 1986 change in the federal tax code that increased the capital-gains rate to 28 percent and ended the practice of allowing real estate losses to generate large tax write-offs, said Hessam Nadji, managing director of research and advisory services at brokerage Marcus & Millichap in San Francisco.
“The second half of 1986 was off the charts,” Nadji said in a telephone interview. “We did about a year’s worth of business in about four months. There was such a frenzy to sell and book profits before the tax laws changed.”
The capital gains realized in 1986 almost doubled over the previous year because of the liquidations, Nadji wrote in an August research note.
“Despite the decline in investment values over the last two years, many investors will likely follow this liquidation strategy,” he wrote.
The Congressional Budget Office is projecting that realized capital gains will surge by 29 percent this year to $540 billion, as investors sell holdings such as stocks and property. The estimate assumes the Bush tax cuts expire at year’s end.
The dollar volume of U.S. commercial property offered for sale in July was $13.5 billion, the highest since October 2008, according to Real Capital Analytics Inc. in New York. In September, $14.8 billion worth of property was listed for sale, more than double the amount in the same month last year.
The volume of transactions that closed also more than doubled in September from a year earlier, with $11.5 billion worth of property such as hotels, apartments and office buildings changing hands, according to Real Capital.
The increase in deals could stem from a sense that real estate values are no longer plummeting, rather than tax uncertainty, said Robert Bach, the Chicago-based chief economist at commercial-property broker Grubb & Ellis Co.
Supply and Demand
“The tax issues are sort of overwhelmed by the broader issues of supply and demand,” Bach said in an interview. “There’s a limited number of properties, and maybe the increase is from the fact that buyers and sellers are coming to common ground as contrasted with a year ago, when there was little clarity on pricing and nobody was doing anything.”
Sellers motivated by a change in tax rates must weigh whether possible taxes saved by striking a deal now will outweigh any price appreciation they can capture in the future, said Ben Thypin, an analyst at Real Capital.
A hypothetical property sold for $20 million now with a capital gain of $3 million would generate taxes of $450,000 at the current 15 percent rate, Thypin said. If the rate increases to 20 percent, the tax on the same transaction in 2011 would be $600,000. The difference would be less than 1 percent of the sales price.
“If you have a relatively small basis, your price does not have to increase that much in order to compensate” for the extra tax paid, Thypin said.
The higher the capital gain, however, the more the seller would need to recover from a future sales price to offset the tax, he said.
U.S. commercial property prices tumbled for a third straight month in August to the lowest level in eight years, Moody’s Investors Service said on Oct. 19. The Moody’s/REAL Commercial Property Price Index fell 3.3 percent from July and is down 45 percent from its October 2007 peak.
With the exception of “very high-quality assets” in coastal urban areas such as New York and San Francisco, “there’s really no appreciation at a broader market level,” said Nadji of Marcus & Millichap. “If you sell a year from now not only will you still be dealing with sluggish valuation, but another 5 percent” in taxes.
Selling income-producing real estate ahead of the possible tax change triggers the question of how to invest the proceeds in an environment where investors are scouring for yield, said Alan Dlugash, a tax partner at New York-based accounting firm Marks Paneth & Shron LLP.
“It’s not going to be easy for them to invest the money and get the same rate of return,” Dlugash said.
Real estate owners concerned about capital gains taxes have the option of using a so-called “1031 Exchange” which allows them to defer payment of those taxes by selling one property and then buying a similar one, according to Nadji. The share of commercial transactions that involve such an exchange “will increase substantially” if the capital gains rate rises to 20 percent, he said in the August research note.
The disincentive to doing that is that some sellers may simply want to liquidate, while others may not have another property lined up to buy, he said.
“People typically know what they want to exchange into,” Nadji said. “There’s less clarity into that right now.”
Clients are coming to Eric Anton’s office seeking advice on whether uncertainty over tax policy is a good enough reason to sell, said Anton, executive managing director for Eastern Consolidated, a New York investment sales brokerage.
“We’re definitely having a lot of those conversations, mostly with long-term New York-based owners,” Anton said. The longer a property had been held, the larger the profit built in, and the more likely the owner is motivated to sell on capital-gains concerns, he said.
“Three years ago it wasn’t a topic, whereas now it’s one of the key decision-making factors,” Anton said. “The real concern is that the lame-duck Congress comes back and makes massive tax increases, because they can.”
Tax rates will rise for everyone if no action is taken, Prante of the Tax Foundation said. The more likely scenarios are that Congress temporarily extends the tax cuts to all Americans for one or two years, or temporarily continues the cuts for all but a small subset of high-income individuals, such as those who earn $1 million or more, he said. Personal residences by and large aren’t subject to capital gains taxes.
End of Year Deadline
Michael Haas, chief executive officer of property holding company Direct Invest USA Holdings LLC, decided in September to sell four office buildings in northern Virginia and Philadelphia after following the Congressional debate that month on the tax rates, he said.
One of the properties, a $40 million Virginia building leased to a federal military office, is now in contract to be sold -- with the contingency that the deal close by the end of the year. As of yesterday, it appeared the buyer may not be able to meet the deadline, Haas said in a telephone interview.
“I said, ‘If you don’t want to close before the end of the year I’m just going to keep it,’ ” he said.
The other three properties, all of them leased to the government, will also be taken off the market if they fail to sell this year, said Suffolk, Virginia-based Haas, who hired Marcus & Millichap to market his buildings. Haas said he and his partners aren’t interested in a 1031 exchange strategy because “sometimes people want to do other things with the profits” instead of buying another property.
For Haas, not selling his buildings this year means he’ll be a reluctant buyer of property next year.
“The larger transactions are the ones that have large profits and allow people to do larger reinvestments,” Haas said. “If you stop that, you’re going to have more people sitting around waiting.”