Reviewing Capital Gains Taxes

As prices continue to spike for many properties in the close in areas and in many cases in the overall metro area, (especially apartments) long time property owners’ might have some profit adrenaline running through their veins and are thinking that it may be time for“taking some chips off the table” to take advantage of this somewhat unexpected rise in property values after the big downturn 5-6 years ago. “As property values have risen and interest in well positioned, quality commercial real estate is reaching a fevered pitch in some markets and product types, owners are looking at taking advantage of a significant value gains in their investments but the tax landscape has changed somewhat over the preceding years which property owners do not often realize” says CPA Joel Fitkin. While we can get stuck in the weeds looking at the cornucopia of tax changes over the last 30 years I will stick with concentrating on long term capital gains rates as that is what affects commercial real estate most profoundly.

A Little Bit of History

Taxes for both short term and long term capital have been around as long as the general income tax system which has its originations in the passage of the 16th amendment to the Constitution in 1913. Capital Gains taxes like rates for ordinary income has bounced around in the ensuing 100 years based mostly upon political considerations and the growth of government’s funding needs (defense, wars, and social programs). Rates bounced around in the mid to high 20% range from the 1950’s into the 80’s. Generally however, capital gains tax rates have had a preferred and lower rate than ordinary income throughout much of its history to align with the general philosophy that lower capital gains rates encourages investment of capital and helps facilitate the movement of money throughout the economy to provide capital for much needed investments and business formation. 1997 was somewhat of a watershed year when during the Clinton Administration and facing a much more Republican congress, Clinton forged a tax cut agreement with Congress which resulted in the long term capital gains taxes (along with other tax rates) dropping from 28% to 20%. With the dot com bust resulting in a “mini-recession” and George Bush and more republicans coming into office in 2001 another tax cut deal was made that reduced long term capital tax rates (and for dividends too which were taxed at ordinary income tax rates up to 39.6%) to 15% with a 10 year provision. President Obama faced like many presidents with political setbacks in the midterm elections of 2010 agreed to a two year extension of the Bush area tax cuts but the acrimony and polarization of congress coming into the 2012 election stymied both Republican and Democratic sides coming to a long term deal regarding Bush’s original tax policies from 12 years earlier as well as addressing other issues like the Affordable Care Act (Obamacare) which in press circles came to be termed the “Fiscal Cliff” controversy. What resulted was some brutal wrangling in the fall of 2012, is the law that was signed in January 2013 which is a mish-mash of certain Bush tax cuts expiring while some staying put and for long term capital gains, a new additional tax. As far as long term capital gains rates the overall rate stayed at 15% except for individuals earning more than $411,000 it moved to 20%. The kicker for many was the implementation of a 3.8% tax for individuals earning $125,000 or more (for couples it is $250,000) as a result of the Affordable Care Act (Obamacare). So in selling a long term capital asset (commercial real estate) people that have healthy incomes will be faced with a tax of 23.8% on the gain and at lesser income levels it will be 18.8%. Hold on, we are not done yet when looking at a sale of a property.

State of Oregon Taxes

I love Oregon, don’t you? But maybe not so much if you are looking to cash out of a long depreciated commercial property because of our lack of sales tax we as a state depend heavily on one of the highest state income and capital tax rates in the country. 41 states have an income tax and if you look at Oregon’s highest tax bracket which covers income over $125,000 (It only drops to 9% below that level) Oregon’s income rates come in third behind Hawaii (which has better surfing and Mai Tais) and tax crazy California. Oregon does not really differentiate on capital gains taxes which has the same rate as ordinary tax rates so add 9.9% to federal capital gains rates (for incomes over $125,000)when selling that property. We are still not done.

Depreciation Recapture

Never heard of this tricky little term? You will when you go to sell that building you have owned for a long time that has been depreciated. One thing great about commercial real estate, namely structures (not land) is that it allows you to depreciate the value of buildings you own to reflect technically what is its economic life or usefulness. It basically helps you offset income and thus pay less taxes on income which is a great idea. Currently that depreciation schedule for commercial buildings is 39 years (tenant improvements can be depreciated over 15 years) which is for buildings bought or “placed into service” after 1993 where before that depreciation schedules were 15-19 years. Depreciation allows you offset income dollar for dollar your rents and is beyond the property’s income one of the best economic benefits that owning commercial real estate offers. A simple example is if you have a $1,000,000 value for the structure when you bought the property, you take 1/39th of that value and reduce you income by that number each year you own that property. In this case, that is approximately 2.56% a year or $25,641 which is a significant reduction of your ordinary income and thus taxes. Most buildings have a life longer than 39 years and thus can be depreciated over much longer periods as when they change hands depreciation starts all over again. You cannot depreciate the land which in the government’s eyes does not deteriorate over the years. The ratio (percentage) of the value of the building to land is established when you buy the property which means you have to establish at time of acquisition separate values for the building and the land which is a key component to maximizing fairly your depreciation. Higher building to land ratios give you more of the overall value of the real estate asset from which you derive depreciation benefits. But that great depreciation tax benefit can come back to get you somewhat when you go to sell that property especially ones you have owned for a long time. Say you have owned that million dollar building for a long time and it is fully depreciated and you sell it for $2 million (again building value not the land). That million dollars of the original value you depreciated gets “recaptured” when you sell by the good old IRS at the rate of 25%, which is almost double the standard 15% capital gains rate or in this case a tax of $250,000 versus what would be standard capital gains rate where the tax would be $150,000. Even if you were somewhat financially clueless and did not take the depreciation on any of your taxes or in some of the years you owned the property you have to pay the recapture rate as if you did. But if the property is in the city of Portland/Multnomah County you get one more blow to the pocket book.

Business License Tax/Multnomah County Income Tax

You know that if you operate a business in the city of Portland you pay a couple of taxes based on income (Adjusted Gross meaning after deductions). The City of Portland charges you 2.2% (Business License tax) and Multnomah County gets you for 1.45% which applies to the gain you get when selling a property in Portland/Multnomah County. If you say live in Gresham and the property is in Gresham you would avoid the City of Portland tax but still pay the County charge. So potentially add another 3.65%. There are some very limited exceptions on this tax.

This is a simplified explanation as all properties and situations are a bit different and there are some exceptions and your trusted bean counter can come up with specific tax ramifications (and ways to minimize the tax) given your ownership history with the property. But given Portland does seem to have a commercial real estate market heavy in long term ownership, it gives some pause to long term property owners salivating over that very generous offer that comes knocking at their door to buy their property. But thinking about it long term, all these taxes except the Obamacare surcharge has always been there for some time so there is not much new here and historically still probably below average taking into account some of the rates from the not too distant past which were considerably higher. Tax deferred or 1031 exchanges are still the big and much used solution to avoiding the plethora of capital gains taxes which many astute and seasoned commercial real estate owners know well and take advantage of which involves buying another property for at or above the value of the property you are selling thus deferring the gain. But with interest and values bouncing back strongly for commercial real estate, owners contemplating an exchange are just not finding “reasonable” real estate investment alternatives that replace the returns and sense of comfort and familiarity they may have had with the property and product type they are selling. The half glass full view is that these taxes have been around for a long time and historically may be on the lower end of spectrum if you look back decades where gains were taxed at high ordinary income levels. Sellers getting big premiums or have properties that are close to being fully depreciated or are facing a big bill for deferred maintenance may justify absorbing capital gains taxes prompting some to justify a sale. Though somewhat out of resignation, one property owner told me recently “Though I have to pay a bunch in taxes, the increased value I am getting for my property helps me not be as pissed off about the taxes I am paying in selling my property”.