Capitulating over capital gains

Uncertainty about the expiration of capital gains tax cuts at the end of this year has some New York City real estate owners selling now to beat a potential increase in their tax bill later.

While Washington has been very publicly debating the upcoming expiration of the Bush-era federal tax cuts, most of the attention has been on the changes in how income is taxed. But those cuts under Bush also impacted taxation of capital gains, where the top rate was chopped from 20 percent to 15 percent. Unless Congress votes to extend the cut, the top rate will bounce back to 20 percent at the end of this year.

Commercial brokers and experts in the investment sales market say that fear surrounding a capital gains tax increase is spurring discretionary sellers in New York to list their properties.

“I’ve talked to a number of people doing this,” said Ben Thypin, a senior market analyst with market research firm Real Capital Analytics.

One company he knows of that’s considering selling is classified as a “C corp,” a general corporation that gets taxed on company income more heavily than some other tax structures, partly because their owners get more personal liability protections.

“If they sell the building now, it would basically get taxed twice, but since capital gains are going to go up so much, they’re considering just taking the hit,” Thypin said.

As The Real Deal has reported, the number of building sales in New York City has increased since last year, but is still far lower than it was before the market crashed. In the first seven months of 2010, RCA recorded 102 transactions in Manhattan, versus roughly 55 for the first seven months of 2009. Yet that’s still much less than the 216 building sales during the same period in 2008, itself a decline from the 412 during the same period in 2007.

There are no hard statistics available on how many of the current sales have been prompted by sellers looking to avoid a possible increase in their tax bills.

Robert Knakal, the chairman of Massey Knakal Realty Services, who has been writing extensively about the capital gains tax on his blog, Street Wise, pointed out that there are more distressed assets and more activity in the market generally.

However, he said, the threat of the sunset on the capital gains tax cut “is having a positive impact on the market, in that there are a number of people who are selling today to beat [it].”

Eric Anton, an executive managing director at Eastern Consolidated, said brokers are advising owners, especially those who have depreciated their assets or finished their improvements, to take advantage of the current capital gains tax rates and sell now.

“There is much more sales activity than there was this time last year,” he said. “I think maybe a quarter of that is owners who just want to sell to protect their capital gains tax rates, and maybe a quarter are distressed sales, and the other half are just regular sales.”

Still, even if sellers are eagerly trying to unload their properties to beat the possible tax increase, they’re not dropping their prices, Anton said.

“There’s no distress pricing in New York, currently,” he said.

The capital gains tax affects all types of properties, Knakal said. And an increase of 5 percent can mean a difference of hundreds of thousands, or even millions, of dollars to the seller.

To calculate the amount of a property’s value that the capital gains tax would apply to, Knakal explained that owners would take what was originally paid for the property, depreciated over time, and add the cost of any capital improvements. That sum would be subtracted from the sale price of the property to arrive at the taxable amount. Then, depending on which tax bracket the seller falls within, he’s either taxed at a rate of 0 percent or 15 percent (which could go up to 10 percent or 20 percent next year if the cut sunsets).

Virtually anyone who sells a building falls into the higher tax bracket. Thus, if a buyer paid $2 million for a building that over the course of 25 years depreciated to $1 million and the buyer put in $500,000 worth of improvements, his initial basis would be $1.5 million. When the buyer sold the building for $10 million, he would pay a capital gains tax on $8.5 million. In this example, a 5 percent increase in the tax rate would cost the seller $425,000.

“As the gains tax goes up, it becomes more expensive to sell, so less people decide to sell,” Knakal argued. “We saw this happen in New York in the late 1980s. When the Cuomo tax was in effect, you saw transaction volume fall off the table, because it was too expensive to sell, and then you saw that when the Cuomo tax was repealed, the aggregate dollar amount of tax collections actually went up, because there was more sales volume.”

The “Cuomo tax,” which went into effect under then-governor Mario Cuomo, added a 10 percent surtax on gains on commercial real estate transactions of more than $1 million. The tax was later repealed under Governor Pataki. Currently, like most states, New York taxes capital gains at about the same rates it taxes income, with city residents paying the same top rate of 12.9 percent on capital gains, as they do on salary.

“I did the gains tax only because the state needed the money desperately. When the need went down, then the need for the tax went down. It got easier to repeal it,” Cuomo told the New York Sun in 2006.

Advocates for allowing the capital gains tax cuts to expire, mostly Democrats, argue that the tax largely affects the wealthy, who can afford to pay more to help bolster federal revenues and eradicate a yawning federal budget deficit of more than $1.6 trillion.

However, it remains to be seen if Congress will allow the cuts to expire this time around.

A political strategist familiar with Congressional discussions on the issue, who asked not to be identified, said “there’s going to be an extension of some elements of the Bush tax cuts.

“That’s almost certain,” he said. “The question is, which elements? I’m still not clear on whether capital gains cuts are included.”