The combination of an unstable economic environment and a number of upcoming proposed regulatory changes are making both short and long term planning extremely difficult for commercial real estate owners, tenants and investors.
The combination of an unstable economic environment and a number of upcoming proposed regulatory changes are making both short and long term planning extremely difficult for commercial real estate owners, tenants and investors. As a result, it will be critical over upcoming years to consult with appropriate professionals prior to making lease and purchase decisions. Among the upcoming new challenges that owners and tenants will soon have to deal with are:
1) New Real Estate Tax
On January 1st, a new 3.8% tax on some real estate investments will take effect. When the legislation becomes effective in 2013, a 3.8% tax on some income from interest, dividends, rents (less expenses) and capital gains (less capital losses) may be imposed. The tax will only be applicable to individuals with an adjusted annual gross income (AGI) above $200,000.00 and couples filing jointly with AGI greater than $250,000.00. The new tax was enacted on March 23, 2010, just hours before the final debate on President Obama’s massive healthcare legislation began. It had not been introduced, discussed or reviewed prior to that time. The National Association of Realtors expressed strong objections, but the legislation passed on a vote that followed along party lines. The new tax is sometimes referred to as a “Medicare Tax” because the proceeds from it are earmarked to pay for over half of the total new expenditures in the new health care reform package.
2) Change in Capital Gains Tax
President Obama, in his proposed 2011 budget, is calling on Congress to make a number of tax changes for individuals. Long-term capital gains tax rate would increase to 20%, up from 15% currently. The increased tax on gains will make commercial real estate tax deferral strategies such as 1031 exchanges and installment sales even more viable. A 1031 exchange allows a seller to defer taxes on the capital gain from the sale of a property by exchanging into another (typically larger) property. There are strict criteria which must be followed for legal exchange, and sellers should consult with a qualified 1031 exchange consultant well in advance of consummating a transaction. Installment sales allow the seller to defer capital gains taxes by spreading the gain over several years as proceeds are received.
3) GAAP Accounting Rules
A new standard for real estate accounting is expected to be completed later this year and enacted in 2013. The new standard will have a dramatic impact on future commercial real estate lease and purchase decisions. The standard will require that companies book leases as assets and liabilities on their balance sheets. The change will significantly impact the balance sheets of companies that lease commercial space. This could have a number of implications, including weakening companies in the eyes of investors and activating debt covenants with lenders, as well as affect company credit ratings. While many ratings agencies say they already take into consideration rent obligations, the new standard will require additional disclosures that could shed new light on lease terms.
4) Inflation and a Rising Interest Rate Environment
Inflation causes money to lose value, and any investment that involves cash flows over time (rent streams) is exposed to this inflation risk. The ramifications of this can be serious. During the inflationary periods of the early and late '70s, real estate provided an excellent hedge against inflation. Real estate prices basically kept pace or outpaced CPI growth during these periods while the stock market stagnated. A dollar would have been smartly invested in real estate during this time. Looking at a more recent time period (1986-1991), the stock market outpaced real estate price growth at almost all times (the exception being the ‘87 market crash). In this case, in hindsight, a dollar would have been more smartly invested in the stock market than in real estate. Historically speaking, however, real estate investment has been a good inflation hedge, particularly during periods of high inflation when other market growth stagnates.
Commercial real estate investment, although seemingly increasingly more difficult to navigate, offers a number of tremendous opportunities for a) attractive investment returns, b) leveraging investment equity, c) deferring taxes and d) hedging against volatility in other investment alternatives. It is more important now than ever before, however, to build a professional real estate team to assist in navigating clear of potential pitfalls.