Tax Code on the Minds of Real Estate Investors

By Joey Odom, Stan Johnson Co.
We no more have a crystal ball into what Congress will ultimately do on the issue of tax rates than anyone else. It is clear that the tug-of-war between political parties not only continues but is heightened by the impending return of control over the House of Representatives to Republicans, who are not in favor of any increase in taxes at this time.

With the elections behind us, a lame-duck session in Congress under way, and government officials looking for ways to close the gap between revenues and deficit, tax policy issues are once again at the forefront for many Americans.

Real estate owners in particular are mindful of what a change in the current capital gains tax rate might mean for the industry and for their own investments. The current federal capital gains tax rates (for most taxpayers, 15 percent for long-term gains) are the result of reduced rates implemented under the Bush Administration. These reduced rates are set to expire at the end of 2010—so if allowed to expire, the long-term capital gains tax rate for most taxpayers would increase to 20 percent. President Obama has supported an increase in the capital gains tax as part of the budget he proposed earlier this year.

We no more have a crystal ball into what Congress will ultimately do on the issue of tax rates than anyone else. It is clear that the tug-of-war between political parties not only continues but is heightened by the impending return of control over the House of Representatives to Republicans, who are not in favor of any increase in taxes at this time.

What we can tell you with certainty is that both before and since the election, the brokers at Stan Johnson Co. have seen a mixed reaction to the possibility of increasing capital gains tax rates among net lease property owners. On the one hand, there has not been a rush by sellers—as some earlier in the year might have expected—to dispose of properties prior to year-end for fear of taxes.

On the other hand, the potential for an increase in capital gains tax rates has been a significant impetus for a number of our clients mandating a year-end closing. Although the concern has been somewhat mitigated by the recent elections, we are still seeing the issue as a driving force behind some sellers’ decisions to sell now, rather than risk a potential tax increase next year. This is particularly true in cases where the owners have owned their assets for long periods of time and thus would, upon sale, enjoy a significant capital gain.

Of course, if the capital gains tax rates were to be increased in 2011, an argument could be made that property owners who pursue sales in the future will have additional motivation to do a 1031 Exchange into another property investment—protecting more of their profits from the sale by deferring the tax with an exchange. This could lead to an increase in investment sales activity, particularly for the net lease property marketplace, next year.

At this point in time, if sellers do not already have their property under contract, they may very well not be able to close a deal by year-end. Additionally, we believe net lease property owners should consider that there is a limit to the potential-capital-gains-rate-increase motivation. In a declining cap rate environment, sellers must determine the point at which the benefit to selling this year to avoid a capital gains tax rate increase of 5 percentage points is outweighed by waiting for sale with a realistic cap rate that may, in fact, net greater proceeds regardless of a tax increase. Particularly as net lease property investment sales volume and values improve, with realistic expectations it may make more sense for some sellers to wait until 2011.

Another tax-related issue of consequence to real estate investors that may resurface in the weeks and months to come is a potential change to the rules by which carried interest in real estate investment partnerships is taxed. Carried interest is the portion of profits received by a general partner upon the sale of an investment; the carried interest tax rules determine how general partners in investment partnerships (including real estate partnerships, as well as other kinds such as private equity and hedge funds) are taxed when the investment is sold.

In an example that could easily be applied to the net lease property market, in many development deals the developer receives an interest in the development partnership once the cash investors receive their initial interest plus an annualized rate of return. If the property is sold after the developer receives its interest in it, the developer’s share of the sale profits would be taxed. Generally, that tax today would be at the capital gains rates; proposed changes, however, would tax the developer’s share of the gain at the higher ordinary income rates, which are currently as high as 35 percent.

The potential increase in taxes on carried interest was hotly debated in the late spring/early summer timeframe—and a number of real estate industry organizations objected to the tax increase, voicing concerns that it would negatively impact both the real estate industry specifically and the overall economy in general—but it was ultimately shelved. However, it may come back to the table after Thanksgiving, when Washington, DC-based Real Estate Roundtable notes in its Nov. 12 “Roundtable Weekly” Congressional legislative will “begin in earnest.”

“Among the many pressing issues on the lame-duck agenda is the fate of a business tax extenders package that would be paid for with a tax hike on real estate partnership carried interest,” the Roundtable notes. “With so many political and policy variables and the array of complex issues in need of discussion during this compressed time period, it remains difficult to predict what Congress will do on the extenders question.”

Earlier in the year, the Roundtable estimated that the proposed carried interest tax increase would affect more than 1 million real estate investment partnerships, and called the proposal “a dramatic, permanent tax increase proposal” that “threatens the fragile economic recovery and constitutes the largest tax increase on the real estate sector in more than 20 years.”

Taxes are a complicated matter. In addition to getting the best net lease property market advice from professionals like the brokers at Stan Johnson Co., savvy real estate investors should always seek advice and strategy from tax professionals and keep abreast of potential tax policy changes being discussed by our lawmakers.