Earlier this week, Robert Knakal (of Massey Knakal Realty Services ) posted this article to his blog:
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.