WEDNESDAY, JUNE 17, 2009
by Dan Rosenberg and Peter LynnChicagoCommercial property owners who plan on cashing out of their real estate investments within the next three to four years have some difficult decisions to make thanks to a looming deadline that could add insult to injury for those already stung by the economic crisis.
That event is the expiration of the current 15 percent tax rate on long-term capital gains, which is set to occur Dec. 31, 2010. Barring some unforeseen intervention by Congress, the rate will automatically revert to its pre-2003 level of 20 percent for those in the 25 percent-and-higher tax brackets. And all indications are the rate is going back up. Ironically, that means 2009-2010 could wind up as a "honeymoon" of sorts for many investment-property owners who otherwise thought the worst would be over by the end of next year.
According to a report released last month by the MIT Center for Real Estate, values on commercial assets fell 5.8 percent in the first quarter of 2009, the fourth straight quarterly drop. And in a widely published survey by
Grant Thornton LLP, a whopping 93 percent of senior financial executives expected values to continue their decline through the end of the year. Looming CMBS defaults cloud the future in terms of a recovery, but the optimistic view seems to be market stabilization in 2010 and the beginnings of an upturn in 2011.
That's just in time for higher taxes to kick in. A five percent bump over today's historically low cap gains rate will, in effect, take the wind out of the sails of the recovery that many would-be sellers are waiting for. And while selling in today's declining market is a bitter pill to swallow, nevertheless that's exactly what we've been advising a number of clients to do.
There are at least two groups of commercial property owners for whom selling in today's less-than-ideal conditions warrants serious consideration. The first group is made up of long-time owners looking to cash out. These owners have a low cost basis and therefore high exposure to capital gains tax. And while they may be cursing property values that are 20 percent off their peak, what's waiting for them on Dec. 31, 2010 is no picnic either.
Our recent sale of a 20-unit apartment building in Humboldt Park illustrates the seller's dilemma. The property, located in the 1300 block of North Kedzie, was acquired in 1996 for $222,000. Twelve years later, the owner was ready to cash out but was hoping to see a sales price of around $2 million. He might have achieved it back when everyone was drinking the Kool-Aid, but neither the income nor the market would support that price today. So he had to make a decision: bet the market would outrun the looming tax hike or bite the bullet and sell now. He played it safe, and the building sold for $1.57 million. The seller had capital gains of $1.348 million, and tax liability of $202,200 based on the current 15 percent rate. Assuming (optimistically) that prices remained steady over the next 18 months, waiting until 2011 would have cost the seller an additional $67,400 based on a 20 percent cap gains rate.
Another important consideration was income. On the Kedzie deal actual income was well below gross scheduled income, and after factoring in property taxes, insurance, utilities and maintenance, the net dipped to where one major capital expenditure could blow through what little cash the property was throwing off. We were able to demonstrate that the owner could achieve similar results - minus the headaches, liability and risk - in the safe haven of government bonds.
Another, less likely candidate to sell ahead of the looming tax hike is the prospective 1031 investor. In today's market, attractive like-kind exchanges are harder to source - not to mention finance.
William Exeter, president and CEO of San Diego-based
Exeter 1031 Exchanges LLC, a qualified intermediary, estimates that approximately 35 percent of today's 1031 transactions aren't being completed, up from an historical average of about 7 percent. Exeter says the majority of the fallout is due to the credit markets, but he attributes some of the aborted deals to the current low tax rate. He says the tax rate will play a larger role as the deadline draws closer.
Among potential 1031 candidates who opted instead to pay the capital gains tax was RayMark Venture LLC, for whom we sold a nine-building retail/mixed-use portfolio in Andersonville in the third quarter of 2008.
RayMark originally sought to add to its portfolio, but when they saw how far values had gone up and cap rates had come down, they decided the timing was better to sell. Furthermore, the tables had already begun to turn on commercial real estate, and looking ahead to a probable Obama victory, RayMark suspected the 15 percent cap gains rate was not long for this world. Ultimately, in RayMark's eyes, the benefits of deferring the capital gains tax did not outweigh the limitations of a 1031 exchange and the risk of buying into a falling market.
RayMark's basis was $11.5 million, and the portfolio fetched $22 million. Capital gains totaled $10.5 million leaving a tax liability of $1.575 million. RayMark gladly wrote the check to Uncle Sam, and they will return to the market, flush with cash, on their own timing and their own terms.
Is there a downside to selling today? Sure. But you can't sell yesterday. And if you're simply playing the odds on where commercial property values and capital gains taxes are headed over the next 18 months, there's a very strong case to be made for going to market now.
Peter Lynn & Dan Rosenberg are co-founders and co-principals of Building Equity Real Estate, a Chicago brokerage firm specializing in commercial-investment property, commercial short sales and commercial REO property. For more information, visit Building Equity's
web site and its
blog.
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