Throughout much of the 20th century, capital gains have been taxed at a lower rate than other income or were only partially exposed to taxation. This lower rate was justified because it encouraged capital formation and investment, fostered risk-taking and helped to offset the effect of inflation on capital gains. History has shown that the tax rate applied to capital gains and dividends has a substantial impact on the way taxpayers handle income from capital.
Even before the last Presidential election, commercial real estate investors were making statements that when they sold their property they wanted to “cash out” because “if Obama gets elected he will raise the capital gains tax to 20% or much more”. Many of these investors have been living up to their word and cashing out of the properties (and condoned by some of their advisors). Now quite frankly, before the election I was calling this the “McCain/Obama effect” because no matter who would have been elected to the office of President, part of their agenda would be to increase the capital gains tax.
Since the election and the subsequent passage of the TARP and TALF and other huge scheduled spending bills have given birth to a second concern among investors and their advisors: hyper-inflation. Let’s dissect these issues on an individual basis and then re-assemble them into a solution for concerned investors and advisors.
Although capital gain tax rates are set to be increased to 20% in 2011, many taxpayers are uncertain as to what rates might be in the future due to what they are hearing from the White House and congress. Let’s compare what happens to the taxpayer who sells today at the current 15% maximum rate versus the same taxpayer electing to defer all capital gain taxes via a §1031 tax deferred exchange and selling at a presumed higher capital gain tax rate of 20% in the future. Assume the following: A taxpayer is selling an investment property for $1,200,000 with $300,000 remaining debt and $820,000 net equity (after cost of sale of $80,000, but before taxes); the taxpayer’s adjusted basis is $400,000 and their gain is $720,000, of which $37,500 is the capital gains tax on depreciation (the 25% tax was signed into law by President Clinton in 1997) and $570,000 (taxed at 15%) is the remaining capital gain; the state tax rate (example-each state is different) is 6% on the entire capital gain of $720,000. This nets to total taxes of $166,200 leaving, net equity after tax, of $653,000. Assume the after-tax sale proceeds are reinvested into another investment property with a 25% down payment (75% LTV), the taxpayer would be able to acquire a property valued at $2,615,200. However, by utilizing a §1031 Tax Deferred Exchange the taxpayer would be able to use the entire gross equity of $820,000 and acquire a property valued at $3,280,000. The incremental value of property acquired would be $664,800.
CALCULATE NET ADJUSTED BASIS
Original Purchase Price (Basis) $500,000
plus Capital Improvement +$50,000
Less Depreciation -$150,000
equals Net Adjusted Basis $400,000
CALCULATE CAPITAL GAIN*
Sales Price $1,200,000
Less Adjusted Basis -$400,000
Less Cost of Sale -$80,000
equals CAPITAL GAIN $720,000
CALCULATE CAPITAL GAIN TAX DUE
Recaptured Depreciation (25% x $150,000) $37,500
plus Federal Capital Gain (15%x$570,000) +$85,500
plus State Tax (GA 6.0%x $720,000) +$43,200
TOTAL TAX DUE $166,200
The elimination of the Alternative Minimum Tax exemption and the creation of Capital Gains Tax Preference items that could create even more taxes are not addressed in this scenario, however, AMT implications need to be considered.
CALCULATE AFTER-TAX EQUITY
Sales Price $1,200,000
Less Cost of Sale -$80,000
Less Loan Balances -$300,000
equals GROSS EQUITY $820,000
Less Capital Gain Taxes Due $166,200
Equals AFTER-TAX EQUITY $653,800
ANALYZE REINVESTMENT - SALE
After-Tax Equity x 4 $2,615,200
ANALYZE REINVESTMENT – EXCHANGE
Gross Equity = Net Equity $820,000
Gross Equity x 4 $3,280,000
Albert Einstein was once asked what he felt was the most powerful force in the world and his answer was “The Theory of compounding Interest”:
Let’s assume that the taxpayer is 35, 40, 50 years old or older and doesn’t need the cash until retirement and replacement investment property appreciates at only 6% per year.
Theory of Compounded Interest:
Utilizing the original $166,200 Tax Deferral Money exponentially creates wealth (e.g. 6% per Year) appreciation of original leveraged amount of $664,800 to over $1,300,000 in 12 Years. Even if the capital gains tax rates (depreciation, capital gains and state blended rises to 40%, the investor is still well ahead of the game.
Also, there is no limit to the number of exchanges a taxpayer can effect , therefore if the taxpayer decides that a replacement property has peaked in value and effects other §1031 exchanges to leverage their additional gains/equity and deferred capital gains taxes into other opportunistic replacement properties.
Hyperinflation:
If our national spending habits do create an inflationary economy; what is one of the best hedge assets to have in one’s portfolio? Commercial Real Estate: and if we see inflation rates skyrocket to 20% or more, the exchanger’s $166,200 tax deferral that leveraged the additional value of $664,800 would double that value in a lot less time than 12 years.
Conclusion:
Investors and their advisors should examine all factors regarding the individual investor's financial goals and tax situations and before they make hasty uninformed decisions.
Copyright William B. Hood, 2009
Monday, May 25, 2009
Sunday, May 17, 2009
2009 Commercial Real Estate Trends
2009 Commercial Real Estate Trends: Taking Advantage of Opportunities and Avoiding Tax Traps in Today’s Distressed Real Estate Markets
2009 Trends in the CRE Market Place
The federal government has infused unprecedented massive amounts of money into financial markets nationwide, yet the credit crunch continues; and when lenders are loaning money the new loan rates are higher and loan to value ratios are lower. The same lenders are looking for a Debt Coverage Ratio that is above 1.2 and often in the 1.25-1.35 + range. Lenders are also looking at higher cap rates for determining value.
Sale-Leaseback transactions are increasing as businesses seek alternative sources of working capital from existing real estate assets.
Due to higher priced oil and future projected consumption, the energy sector is becoming more popular as an investment. Adding to that is the ensuing need to become energy independent and therefore solar farms, wind power and other alternative energy are gaining favor with investors.
“Green” initiatives are being aggressively pursued due to decreasing construction costs and the ROI on sustainability due to operating efficiencies and tenant demand.
In the commercial real estate market many investors are under water due to note balances that are in excess of Fair Market Value and/or not being able to pay the note balance on the due date (with many coming due in 2009-2010).
Ominous Tax Consequences Looming for Commercial Borrowers with Non-Performing Debt
Loan balances that are in excess of fair market value of the property could inflict onerous taxable events upon unsuspecting investors if there is COD (cancellation of recourse debt and/or deeding-in lieu or actual foreclosure by the lender (recourse and/or non-recourse debt in excess of the adjusted basis on the property) triggering capital gain tax recognition; resulting in investors having little or no cash to pay the debt or the tax liabilities.
With recourse debt; there are two types of tax liabilities that are created where the investors will recognize capital gain (or loss); the difference between the fair market value of the property (immediately prior to the disposition) and the property’s adjusted basis (purchase price plus capital improvements less depreciation). Many investors believe they have a loss, when in fact they may have a huge capital gain (especially a BIG (built in gain from a previous tax deferred exchange). In addition to the capital gains tax consequences, cancellation of debt (COD) triggers recognized ordinary income to the extent of the deficiency when fair market value is less than recourse liability, unless excepted (proof of insolvency, bankruptcy, etc.).
THE AMERICAN RECOVERY AND REINVESTMENT ACT OF 2009 – STIMULUS AND TAXES
For tax purposes, the cancellation of debt is taxable income in the year cancelled. The Act provides that for debt discharges in 2009 and 2010, a taxpayer can elect to have the debt discharge income included in gross income ratably over 5 years, starting in the fifth tax year (fourth tax year if the discharge occurs in 2010) after the year of discharge. Unfortunately, at this point in time, this election is not available to real estate investors. Therefore, the COD will remain as ordinary taxable income in the year the debt is discharged.
Following are examples of the onerous tax consequences that can occur from foreclosure, deed-in-lieu, and “workouts” that discharge recourse debt:
Calculation of Adjusted Basis & Debt:
Original Purchase Price (Original Basis includes $300,000 Land) $2,200,000
Depreciation Basis $1,900,000
Less: Depreciation $600,000
Adjusted Basis (includes land) $1,600,000
Calculation of COD Recognized Ordinary Income:
Amount of Loan Outstanding $2,000,000
Fair Market Value (Mark to Market) $1,800,000
equals COD “Ordinary” Income $200,000
Calculation of Recognized Capital Gain Income:
Fair Market Value $1,800,000
minus Net Adjusted Basis $1,600,000
Additional Capital Gain Income $200,000
Total Recognized Income: Ordinary & Capital
Gain Income $400,000
Note1): the “Ordinary” Income Tax on the $200,000 created by the COD could be as much as $80,000 + (35% Federal + 6% GA state tax (each state tax is different)) There could be more taxes if the additional ordinary income may eliminate the Alternative Minimum Tax exemption amount (another possible onerous tax consequence).
Note 2): (The Capital Gains Tax on depreciation is “Front Loaded”) 25% X $200,000 = $50,000 + 6.0 % GA state tax (each state is different) x $200,000 = $12,000. Total capital gains tax would be approximately $60,000 +. The total potential taxes would be $140,000 + (each state income tax will make a difference).
And, there could be even more taxes levied on the investors if the additional income eliminates the Alternative Minimum Tax (AMT) exemption amount and the Capital Gains Tax Preference items trigger Alternative Minimum Tax (another possible onerous tax consequence).
Non-Recourse Debt
And just when investors think it’s over, it’s not; if there is non-recourse debt on the distressed property, the investors will recognize capital gain income in an amount equal to the total debt secured by the property less the property’s adjusted basis.
Calculation of total Non-Recourse debt recognized as income $2,000,000
Less: adjusted basis $1,600,000
Recognized capital gain $400,000
Note 3: (The capital gain tax on depreciation is “Front Loaded”) 25% X $400,000 = $100,000 plus (Georgia state taxes) 6.0% x $400,000 = $24,000 The total taxes would be approximately $120,000 + (each state income tax will make a difference).
Unfortunately, many real estate investors are very much unaware of these onerous tax consequences; and by conveying title (deed-in- lieu or foreclosure) and/or debt discharge from “workouts” they could end up with tax bills and debt that they can’t pay.
There are Solutions available for Investors and Lenders
Now for some viable Win-Win solutions; Investors that are holding non-performing/under performing properties (or even performing properties) may be able to mitigate or eliminate onerous tax consequences due to COD and capital gain taxes (recourse and non-recourse debt) via strategies that may include “§1031 Workout Strategies”. The scenarios could include selling the property and exchanging it for a property of equal or greater value and equal (or greater) debt, thereby deferring the entire capital gain taxes. A partial exchange could also be an option with the results of deferring part of the capital gains taxes. Part or all of capital gains taxes deferred savings could be used to pay down the recourse debt and mitigate or eliminate the ordinary income recognition.
On the flip side the buyers of these distressed commercial real estate properties could be investors looking for opportunities to acquire valuable properties at discounts through a number of IRC §1031 strategies themselves. These §1031 Tax Deferral Strategies can be structured where the investors have properties scheduled for relinquishment but wish to wait for the market to stabilize in order to get the best price. Through an Exchange Accommodation Title Holder/Qualified Intermediary; the acquisition of the non-performing property direct from the current owner or the lender’s REOs and/or the notes portfolio now (and via the notes; the subsequent acquisition of the underlying properties) and afford themselves ample time (via a §1031 reverse exchange - Safe Harbor or non-Safe Harbor) to sell their scheduled relinquished properties.
If a buyer of the exchange property is short on capital, there are also §1031 Tax Deferred Exchange strategies utilizing creative "Seller Financing" options that can help the exchanging investors defer much or ALL of the capital gain taxes on the sale of the Relinquished Property.
All of the above strategies may very well create Win-Win Scenarios (for lenders, investors and borrowers alike). The lender is cashed out to the fullest extent possible, the investors own valuable properties at a discount to FMV and the distressed borrowers have mitigated onerous tax consequences. In addition, current commercial occupant(s) may have uninterrupted use of the property via leases negotiated i.e. lease payments vs. extensions or even Lease/Option to Buy?
There may be even Win-Wins in the residential sector where viable current residents remain in their homes? Could negotiations lead to the families paying less rent than previous mortgage payments with a lease/option to buy? The Big win? Neighborhood home values stabilize (due to fewer foreclosures which would depress the comparables even more).
Caveat:
Each individual investor, borrower and property situations should be analyzed by a team of skilled professionals. Each situation will fall under the “Snow Flake” theory. No two will be exactly alike.
Copyright William B. Hood, 2009
William B. Hood. CPA is the Southeast Division Manager with Asset Preservation, Inc. Bill is a graduate of Seton Hall University with a B.S. degree in Public Accounting. Bill is a Certified Public Accountant and is a member of the American Institute of Certified Public Accountants, Georgia Society of Certified Public Accountants, the Atlanta Commercial Board of Realtors and CREW.
2009 Trends in the CRE Market Place
The federal government has infused unprecedented massive amounts of money into financial markets nationwide, yet the credit crunch continues; and when lenders are loaning money the new loan rates are higher and loan to value ratios are lower. The same lenders are looking for a Debt Coverage Ratio that is above 1.2 and often in the 1.25-1.35 + range. Lenders are also looking at higher cap rates for determining value.
Sale-Leaseback transactions are increasing as businesses seek alternative sources of working capital from existing real estate assets.
Due to higher priced oil and future projected consumption, the energy sector is becoming more popular as an investment. Adding to that is the ensuing need to become energy independent and therefore solar farms, wind power and other alternative energy are gaining favor with investors.
“Green” initiatives are being aggressively pursued due to decreasing construction costs and the ROI on sustainability due to operating efficiencies and tenant demand.
In the commercial real estate market many investors are under water due to note balances that are in excess of Fair Market Value and/or not being able to pay the note balance on the due date (with many coming due in 2009-2010).
Ominous Tax Consequences Looming for Commercial Borrowers with Non-Performing Debt
Loan balances that are in excess of fair market value of the property could inflict onerous taxable events upon unsuspecting investors if there is COD (cancellation of recourse debt and/or deeding-in lieu or actual foreclosure by the lender (recourse and/or non-recourse debt in excess of the adjusted basis on the property) triggering capital gain tax recognition; resulting in investors having little or no cash to pay the debt or the tax liabilities.
With recourse debt; there are two types of tax liabilities that are created where the investors will recognize capital gain (or loss); the difference between the fair market value of the property (immediately prior to the disposition) and the property’s adjusted basis (purchase price plus capital improvements less depreciation). Many investors believe they have a loss, when in fact they may have a huge capital gain (especially a BIG (built in gain from a previous tax deferred exchange). In addition to the capital gains tax consequences, cancellation of debt (COD) triggers recognized ordinary income to the extent of the deficiency when fair market value is less than recourse liability, unless excepted (proof of insolvency, bankruptcy, etc.).
THE AMERICAN RECOVERY AND REINVESTMENT ACT OF 2009 – STIMULUS AND TAXES
For tax purposes, the cancellation of debt is taxable income in the year cancelled. The Act provides that for debt discharges in 2009 and 2010, a taxpayer can elect to have the debt discharge income included in gross income ratably over 5 years, starting in the fifth tax year (fourth tax year if the discharge occurs in 2010) after the year of discharge. Unfortunately, at this point in time, this election is not available to real estate investors. Therefore, the COD will remain as ordinary taxable income in the year the debt is discharged.
Following are examples of the onerous tax consequences that can occur from foreclosure, deed-in-lieu, and “workouts” that discharge recourse debt:
Calculation of Adjusted Basis & Debt:
Original Purchase Price (Original Basis includes $300,000 Land) $2,200,000
Depreciation Basis $1,900,000
Less: Depreciation $600,000
Adjusted Basis (includes land) $1,600,000
Calculation of COD Recognized Ordinary Income:
Amount of Loan Outstanding $2,000,000
Fair Market Value (Mark to Market) $1,800,000
equals COD “Ordinary” Income $200,000
Calculation of Recognized Capital Gain Income:
Fair Market Value $1,800,000
minus Net Adjusted Basis $1,600,000
Additional Capital Gain Income $200,000
Total Recognized Income: Ordinary & Capital
Gain Income $400,000
Note1): the “Ordinary” Income Tax on the $200,000 created by the COD could be as much as $80,000 + (35% Federal + 6% GA state tax (each state tax is different)) There could be more taxes if the additional ordinary income may eliminate the Alternative Minimum Tax exemption amount (another possible onerous tax consequence).
Note 2): (The Capital Gains Tax on depreciation is “Front Loaded”) 25% X $200,000 = $50,000 + 6.0 % GA state tax (each state is different) x $200,000 = $12,000. Total capital gains tax would be approximately $60,000 +. The total potential taxes would be $140,000 + (each state income tax will make a difference).
And, there could be even more taxes levied on the investors if the additional income eliminates the Alternative Minimum Tax (AMT) exemption amount and the Capital Gains Tax Preference items trigger Alternative Minimum Tax (another possible onerous tax consequence).
Non-Recourse Debt
And just when investors think it’s over, it’s not; if there is non-recourse debt on the distressed property, the investors will recognize capital gain income in an amount equal to the total debt secured by the property less the property’s adjusted basis.
Calculation of total Non-Recourse debt recognized as income $2,000,000
Less: adjusted basis $1,600,000
Recognized capital gain $400,000
Note 3: (The capital gain tax on depreciation is “Front Loaded”) 25% X $400,000 = $100,000 plus (Georgia state taxes) 6.0% x $400,000 = $24,000 The total taxes would be approximately $120,000 + (each state income tax will make a difference).
Unfortunately, many real estate investors are very much unaware of these onerous tax consequences; and by conveying title (deed-in- lieu or foreclosure) and/or debt discharge from “workouts” they could end up with tax bills and debt that they can’t pay.
There are Solutions available for Investors and Lenders
Now for some viable Win-Win solutions; Investors that are holding non-performing/under performing properties (or even performing properties) may be able to mitigate or eliminate onerous tax consequences due to COD and capital gain taxes (recourse and non-recourse debt) via strategies that may include “§1031 Workout Strategies”. The scenarios could include selling the property and exchanging it for a property of equal or greater value and equal (or greater) debt, thereby deferring the entire capital gain taxes. A partial exchange could also be an option with the results of deferring part of the capital gains taxes. Part or all of capital gains taxes deferred savings could be used to pay down the recourse debt and mitigate or eliminate the ordinary income recognition.
On the flip side the buyers of these distressed commercial real estate properties could be investors looking for opportunities to acquire valuable properties at discounts through a number of IRC §1031 strategies themselves. These §1031 Tax Deferral Strategies can be structured where the investors have properties scheduled for relinquishment but wish to wait for the market to stabilize in order to get the best price. Through an Exchange Accommodation Title Holder/Qualified Intermediary; the acquisition of the non-performing property direct from the current owner or the lender’s REOs and/or the notes portfolio now (and via the notes; the subsequent acquisition of the underlying properties) and afford themselves ample time (via a §1031 reverse exchange - Safe Harbor or non-Safe Harbor) to sell their scheduled relinquished properties.
If a buyer of the exchange property is short on capital, there are also §1031 Tax Deferred Exchange strategies utilizing creative "Seller Financing" options that can help the exchanging investors defer much or ALL of the capital gain taxes on the sale of the Relinquished Property.
All of the above strategies may very well create Win-Win Scenarios (for lenders, investors and borrowers alike). The lender is cashed out to the fullest extent possible, the investors own valuable properties at a discount to FMV and the distressed borrowers have mitigated onerous tax consequences. In addition, current commercial occupant(s) may have uninterrupted use of the property via leases negotiated i.e. lease payments vs. extensions or even Lease/Option to Buy?
There may be even Win-Wins in the residential sector where viable current residents remain in their homes? Could negotiations lead to the families paying less rent than previous mortgage payments with a lease/option to buy? The Big win? Neighborhood home values stabilize (due to fewer foreclosures which would depress the comparables even more).
Caveat:
Each individual investor, borrower and property situations should be analyzed by a team of skilled professionals. Each situation will fall under the “Snow Flake” theory. No two will be exactly alike.
Copyright William B. Hood, 2009
William B. Hood. CPA is the Southeast Division Manager with Asset Preservation, Inc. Bill is a graduate of Seton Hall University with a B.S. degree in Public Accounting. Bill is a Certified Public Accountant and is a member of the American Institute of Certified Public Accountants, Georgia Society of Certified Public Accountants, the Atlanta Commercial Board of Realtors and CREW.
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