A Potential Catalyst to Stimulate 2010 Property Sales Activity

This recession has hit the U.S. very hard causing an unprecedented level of government intervention. Trillions of dollars have been committed in spending, bailouts, tax credits and guarantees.  Eventually we must  pay for these financial commitments and we pay for them in the form of higher long-term interest rates, increased taxes or, most likely, a combination of both.

Not only is the federal government running massive and record-setting deficits but most states are in the same position.  While the fed is presently committed to keeping interest rates low (we know they will have no choice but to tighten monetary policy at some point), the tax picture is another story. There is no doubt that taxes are going to increase and increase across the board.  Federal, State and local taxes are going to increase and everyone, even those who were promised no tax increases constantly in pre-election speech after speech after speech.

The Bush administration’s tax cuts sunset at the end of 2010 which will push the federal capital gains rate up from 15% to 20%. It is expected that the present administration will raise this rate also by only three to five percent. They can get away with what looks like a small increase because they are not responsible for the 5% increase already built into the system. So we could be looking at a 23% to 25% capital gains rate beginning in 2011. But wait, there is more….

The healthcare proposals that are going to be debated in congress have politicians scrambling to find ways to pay for the (at least) $1 trillion program. In order to achieve their objective of making this program appear deficit neutral, we are seeing some of the most creative accounting techniques used, most of which increase taxes and on, just about, everyone. Some of these techniques would even make Bernard Madoff blush. (For instance, under the healthcare proposal, we are theoretically deficit neutral because we count revenue over 10 years but spending over only 6. Revenue comes in beginning in 2010 but payments are not made until 2014. I wish we could account for profits this way in the private sector. ) But let’s get back to taxes.

For the first time in over 30 years, we may see the return of income tax bracket creep. Buried deep in the 2,000 page healthcare bill is a provision which will partially repeal tax indexing for inflation. What this provision means is that, as earnings rise over a lifetime, Americans can look forward to paying higher income tax rates even if their income gains are not “real”. Two main features of the current version of the plan are not indexed. The first is the $500,000 threshold for the 5.4% income tax surcharge (does the word “surcharge” really sound more benign than “tax”?). The second is the payroll level at which small businesses must pay a new 8% tax penalty for not offering employees health insurance.

Let’s take a look at the true impact of the surcharge. This tax is set to begin in 2011 on all income above $500,000 for single filers and above $1 million for those filing jointly. Assuming a 4% inflation rate over the next decade (not an aggressive assumption given our fiscal picture), the $500,000 threshold for an individual filer would impact families with the 5.4% surcharge at an inflation-adjusted equivalent of about $335,000. After 20 years without indexing, the surcharge threshold falls to about $250,000.  As the real inflation rate rises, these thresholds drop further.

This mechanism is a covert way for politicians to dig deeper into more worker’s pockets each year without having to legislate tax increases. The negatives of failing to index compound over time, producing a windfall for the government as the years go by hitting unsuspecting taxpayers.

This trick is nothing new and its impact is tangible. For example, in 1960, just 3% of tax filers paid a 30% or higher marginal tax rate. By 1980, the inflation of the 1970’s resulted in that share increasing to 33% of filers! These stealth tax increases, which forced more Americans to pay higher tax rates on phantom gains in income, were widely thought to be unfair. In response, in 1981, as part of the Reagan tax cuts, indexing the tax brackets for inflation was adopted by a bipartisan coalition.

Another example of the impact of this stealth, inflation-ruse, technique can be seen in the performance of the Alternative Minimum Tax. In 1969, when this tax was first passed, it was intended to only hit 1% of all Americans. In 1993, the Clinton administration increased the AMT tax rate. At neither of these times was the tax indexed for inflation. As a result, the number of families hit by this tax more than tripled over the next decade. Today, unless congress passes an annual “patch”, families with incomes as low as $75,000 can be affected.

Importantly for our real estate industry, the 5.4% surcharge has been creatively written to be applicable to modified adjusted gross income. This means it applies to capital gains taxes. Piled on top of the increase caused by the sunsetting of the Bush cuts, our 2011 federal capital gains tax rate would balloon to 25.4%, even without any additional increases imposed by the present administration. If congress acts as expected, the new rate could top 30%.

With such a dramatic increase in the capital gains rate, sellers, who are considering the sale of commercial real estate in the short-term, must seriously consider the implications of this increased cost. Logic would dictate that this dynamic should catalyze an increase in sales activity in 2010 as seller’s rush to take advantage of the low 15% rate.  This increase in sales volume would be welcomed as 2009 will be, by a wide margin, the year with the lowest turnover (in terms of number of buildings sold) of investment property sales since at least 1984 (we do not have records prior to 1984).

The creative accounting in Washington could have another silver lining for our industry. Similar to the way the “modified adjusted gross income” includes capital gains, it also includes dividends. Adding the 5.4% surcharge to the increase caused by the Bush cuts sunsetting, the tax rate on dividends will explode from 15% to 45% ( 5.4% plus the pre-Bush rate of 39.6%). This dramatic increase would shift massive amounts of capital away from equities into other forms of investments, including commercial real estate.

I always try to figure out how our industry is affected by what goes on in Washington. While there may be some positives for commercial real estate, the present shenanigans are troubling. The return of the days without inflation indexing is nothing more than stealth taxation. It would repeal a 30 year bipartisan consensus that it is unfair to tax unreal gains in income. The result will be that millions of middle-class Americans will be hit with new taxes over time with taxes advertised as only hitting “the rich”.

Mr. Knakal is the Chairman of Massey Knakal Realty Services in New York City and has brokered the sale of over 1,000 properties in his career.

10 Responses to “A Potential Catalyst to Stimulate 2010 Property Sales Activity”

  1. 1 hummbumm November 23, 2009 at 10:00 am

    Very interesting. While i agree that not inflation indexing is a stealth tax, the reality is that taxes need to be raised for the whole spectrum of tax payers and not just the high earners, and if this achieves it in a stealthy way, well our macro fiscal situation will still be better off. In the 2008 fiscal federal budget (well before Obama)discretionary spending ex. entitlements, defense and interest was $479b and the deficit that year was roughly that even in good times. Yes we can cut defense spending, and maybe a little on entitlements but the reality is that taxes need to go up. there is no way around it. It was obvious that that was going to need to occur well before the current crisis, and even more obvious now. The ideas of targeting the rich at first and then through inflation having it trickle down is a pretty good idea, because if left to legislation you would have the rich pay now and the rich pay more later, which concentrates the tax base too much.

  2. 2 Tim Galllen November 24, 2009 at 11:05 am

    Why is that that the first priority is always to raise taxes – instead of cutting fat and increasing efficiency. I just saw an interview on the heath care debate warning that small business people are already suspicious of this “crisis” because no one really knows what we are paying for. There is no bill broken down, just a co-pay figure that is a percentage of a number. Curiously, the same ignorance of costs plays here as well.

  3. 3 Mr. Bippy November 29, 2009 at 7:08 pm

    It does seem logical that a looming increase in the capital gains tax would encourage sellers to transact sooner than later. However, I wonder how much of a bounce this will have on velocity in the overall market. Some of the commercial markets, especially large retail and office markets, values are so far off due to the lack of larger scale financing. Now, even if it is the desire of the owner of a property to sell before the increases come in to effect, they might hold past the expiration date of the Bush tax cuts in hope that financing returns. The cost of holding on for better credit days may allow for significant appreciation from where the property could be sold today. Therefor, a seller might wait and begrudgingly pay the higher tax rate but on a signifcantly higher price yielding them a larger after tax profit.

    The larger taxes on the dividends seem outrageous in comparison to what is being paid today. It would definitely encourage investors for other avenues to put their equity to work. But, wouldn’t this also make REIT’s less attractive as well? Therefor taking away some of the investors from the market?

    It seems like we are all in for an increase in taxes and we really can’t do anything about it. It is unfortunate but our spending has been out of control and we need to start paying for our deficit.

    Obama’s health care plan will inevitably increase taxes as well no matter what the CBO says. That becomes more of an ethical question we as Americans have to decide. Do we want to pay more taxes to ensure that every American receives decent affordable health care?

  4. 4 hummbumm November 30, 2009 at 9:49 am

    Only real source of spending cuts are defense, medicare and social security. Given that these are near political impossibilities, I would rather see taxes go up and a balance budget then continued deficits. We know explicitly what federal govt spending is allocated to. As i mentioned ex. the 4 big buckets of defense, interest on debt and entitlements, true discretionary spending was $478B back in fiscal year 2008 (ends october of that year). so if we cut all of that, education, agriculture, fbi, science, energy etc… we still would be in a hole unless we cut defense in half and cut medicare and social security. Given the near impossibility of the later, tax raises is the way to go.

  5. 5 rknakal December 1, 2009 at 7:20 am

    Hi Hummbumm, thanks for your post. I agree that taxes should go up on everyone, not just on the rich althought the definition of rich seems to be getting lower and lower with each legislative session. Unfortunately, a growing percentage of Americans pay absolutely no federal taxes creating the concentration that you mention.

  6. 6 rknakal December 1, 2009 at 7:22 am

    Hi Tim, thanks for your post. Your points are well made. A breakdown would be nice but may be several hundred pages as the bill is almost 2,000 as it presently stands.

  7. 7 rknakal December 1, 2009 at 7:34 am

    Hi Mr. Bippy, thanks for your post. It almost seems like you are driving in the right lane for a change. I understand your points and I think the one thing that is an assumption that we can’t quickly jump to is that if the financing markets revive themselves that significantly higher prices will result. Based upon how our fundamentals are behaving, healthy appreciation appears to be years off at best. By the time values go up significantly, we may have a new adiministration with a different tax perspective. As for the pros and cons of the healthcare debate, I only want to look at it from a Realestatarian’s point of view and say that more dificit spending will not help us at this time. With the economy in the condition that it is in, the well intended focus of this administration on healthcare and cap and trade are misguided at this time. They should foucs on the economy and creating jobs, jobs, jobs. They are trying to push everything through prior to the midterm elections next year as they have a better probability of passing their agenda. This lack of sensitivity to the economy and the ramification of running up massive debt may come back to bite them in the future.

  8. 8 Carl Todd December 3, 2009 at 9:10 am

    We are like the kid how spends his allowance on toys and candy and not the school books he was given the money for.

    Washington has not learned the lesson we were taught as kids that charity begins at home. We can not solve the world’s economic and social problems alone or as the major financing and physical body while allowing the sources of government income to fly out the door. Buy allowing the off shore manufactured products to enter USA without a compensating import tax to offset the tax income that would have been paid if the goods and services were made here to support the mandated programs started the USA’s falling and now failing cash flow.

    Add our inept analysis of conclusions how to solve our financial dilemma is currently exacerbating our financial hemorrhage such as $1 mill. per soldier to prop-up a corrupt government in Afghanistan that the locals choose as the lesser of two evils and our sound bites equate the Taliban as the Al Qaeda.

    We must first get our house in order by setting a world class example of how to keep a nations decent standard of living for all of its population. To begin with fix New Orleans, our deteriorating infrastructure that increases the inefficiency of our commerce, address the needed updating potable waterof systems, our electric grid while we promote the future need for electric by automobiles, bring our public education to the top of the world’s standards, and so much more you could write a book on.

    All our National needs can only be securely and continued financed from a steady tax stream who’s core comes from domestic personal income and corporate taxes – i.e. stupid – JOBS, JOBS, JOBS!

  9. 9 International Real Estate Directory and Property Listings December 5, 2009 at 11:15 am

    I agree to you Tim Galllen! It is really annoying if they talk of raising taxes. They treat it as their priority! Yeah, we do not know what we are paying for. I hope, taxes would be decreased. It would be a great relief for everyone.

  1. 1 Twitted by CREOPoint Trackback on November 24, 2009 at 7:15 pm

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