Capital gains taxes on real estate transactions could increase by as much as 8.8% in 2013!

Contemplating the sale of a tract of land, commercial real estate, or even a personal residence?

A property owner may want to consider taking action sooner rather than later.

There are two changes on the horizon that could significantly impact profits on residential, Land and Commercial Real Estate transactions: new Medicare surtaxes and the expiration of the Bush tax cuts.

The Patient Protection and Affordable Care Act (PPACA) (a.k.a. Obamacare) has been front and center in the news for the past couple of years since it became law in March of 2010.   Buried within the nearly 1,000 page document are any number of regulations and new taxes … more than one can imagine.

The good or bad news (depending on one’s perspective) is that over the last two years the grim truth about PPACA has been surfacing, as former Speaker of the House Nancy Pelosi revealed in her now infamous statement, “You have to pass the bill so you can find out what’s in it!”

Consider Section 1411 of the bill, where the Medicare surtax is addressed.

What does the healthcare bill have to do with real estate, one may ask?

For the first time, a 3.8% Medicare payroll tax will be applied to investment income — including rents and net gains from disposition of Real Estate – of single taxpayers with adjusted gross income (AGI) above $200,000 and joint filers over $250,000. 

One may think that this only impacts the very wealthy … It may be worth taking another look.  Consider the small farmer or investor living on a meager income, but sells a tract of land or building that yields a capital gain of over $200,000.  Is such a sale subject to the 3.8% tax?

Perform a Google search “The 3.8% Tax: Real Estate Scenarios & Examples” to find a detailed informational brochure available from the National Association of REALTORS® (NAR) that lays out helpful scenarios calculating Medicare surplus taxes on a variety of real estate transactions.

According to NAR, “This new tax was never introduced, discussed or reviewed until just hours before the final debate on the massive health care legislation began.”

And that’s not all.  The healthcare reform legislation also imposes an additional 0.9% hospital insurance (HI) tax on wages in excess of $250,000 for married taxpayers filing jointly and $200,000 for single taxpayers.

Assuming the Supreme Court doesn’t reject Obamacare in its entirety, both of these taxes take effect in 2013.  Taxpayers in the highest brackets could see income tax increases of as much as 4.7% due to the PPACA legislation!

The other grim reaper lurking in the shadows is the fast-approaching expiration of the Bush-era tax cuts.  If those tax cuts expire at the end of this year, capital gains tax rates generally will increase from 15% to 20% (0% to 10% for lower-income).  This increase affects all taxpayers, including small businesses.

“The bulk of these changes will affect individuals, but they will also have a major impact on businesses,” said Jennifer Fair, a CPA with McLean, Koehler, Sparks and Hammond.  “In particular, the highest income tax rate on individuals will increase to 39.6% percent, which is 4.6 percentage points higher than the highest tax rate on corporations. Therefore, although there has been a move in recent years toward pass-through entities, such as LLCs, the C corporation may again come back into favor as individual rates are increased.”

“We don’t expect any legislation on these tax cuts to be passed until after the election,” continued Fair.  “We are planning as if they are expiring, until we hear otherwise.  It is possible the legislation could be passed as late as early 2013 and made retroactive.”

So what is the bottom line of all of these tax increases in the pipeline?

A real estate seller could be facing a combined increase in capital gains taxes of 8.8% next year!

“If all of this hits at the same time, it could send shivers up people’s spines,” said Bill Castelli, Vice President of Government Affairs with the Maryland Association of REALTORS®.  “It’s not clear what is going to happen in Congress.  On one hand, Republicans want to hold out to extend the Bush tax credits, but they have to pass something.  The election results will have a role to play in this, and the economy will have a role to play.  If the economy doesn’t pick up so revenues can fund some of the deficit, it gives Congress less of a choice.”

So what’s a seller of Land and Commercial Real Estate to do?

Sell that property before 2013.  That’s the only sure way to avoid these taxes.

If that is just not practical, one may choose to wait (for what could be several years) for a more robust real estate market, it is highly recommended that one find a competent accountant or financial planner to help with capital gains planning.  Tax planning strategies (including reporting capital gains on the sale of property on an installment basis) can help reduce or defer capital gains income

An additional thank you goes out to Catharine Fairley, CPA and Principal at Draper & McGinley, PA for her guidance and expertise in providing information for this article.

Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland. He is an appointed member of the Frederick County Charter Board. He also writes for TheTentacle.com and Want2Dish.com.

To capitalize or to deduct property development costs?

Land and real estate developers, regardless of size, are faced with tax issues that can have a significant impact on their resources and profits. Some of these issues relate to tracking and capitalizing property development costs. It is important for any real estate developer to be familiar with basic tax concepts regarding capitalization, in order to ensure they are following the required tax rules and are not taking deductions for costs that should be capitalized.

Brokers that acquire real estate with the intent to resell it in a short period of time as well as developers that acquire real estate with the intent to build, improve or develop the property can incur costs that may not be deductible in the current period. Such costs will be recouped either through depreciation deductions over time or recovered upon sale by increasing the cost basis of the property.

What types of costs are subject to capitalization?

Costs incurred to produce the property are not currently deductible. Taxpayers must capitalize all the direct costs of producing the property and the real property’s allocatable share of indirect costs. “Production costs” include the cost to construct, build, develop or improve real property. Processes such as grading and clearing of land, excavating for the purpose of roads, laying foundation or lines for utilities, plumbing and/or electrical work, qualify as production costs. Labor costs such as standard wages, overtime, employee benefits or payroll taxes are also included in direct costs. All indirect costs allocatable to the construction activities, such as rent, repairs and maintenance, insurance utilities and depreciation, should be capitalized as well.

There are costs a developer may incur in the pre-production phase that are also subject to capitalization, if it is more than likely the property will be subsequently developed. Some of these costs include property taxes, government permits, zoning variances or engineering and feasibility studies.

Marketing, selling and advertising costs, although very important to the sale of the property, are not considered construction related costs and can be expensed in the year incurred.

Internal Revenue Service (IRS) regulations may also require the capitalization of interest on debt incurred with respect to a property during the production period. The production period is considered to begin on the first day that any physical production activity is performed (i.e. clearing, grading, demolition, etc.). Production ends when the property is ready to be placed in service or is ready for sale. Completion date can be a problematic subject for those involved in the construction of multi-unit buildings. From a tax perspective, each unit is considered to be independent of others as long as each unit is not contingent on another in order to be sold or placed in service. Capitalized costs, in this case, must be allocated to particular units using some reasonable method accepted by the IRS.

There are other considerations that brokers or real estate developers should take into account before investing.  Knowledge of the capitalization rules and regulations should be a priority for companies as these rules affect the timing of deductions with regards to income taxation.

Article provided by Anca Stradley, MKS&H.

About: McLean, Koehler, Sparks & Hammond (MKS&H) is a professional service firm with offices in Hunt Valley and Frederick, Maryland.  MKS&H helps owners and organizational leaders become more successful by advising them regarding their financial, technology and management needs. Please visit www.MKSH.com for more information.

This post is compliments of the “Knowledge Edge,” a weekly newsletter provided by Rodgers Consulting, Inc., a leading land planning and engineering firm to real estate and land developers throughout the Washington, D.C. Metropolitan area.

MONTGOMERY COUNTY

Tax credits, property tax hikes could help build Clarksburg roads

April 20, 2011
Gazette

The developer of Clarksburg Town Center believes recommendations on how to pay for new roads in the upcounty will hinder his ability to build them. Douglas Delano, vice president of Newland Communities of McLean, Va., said the recommendations from the Clarksburg Infrastructure Working Group, which will be heard by the County Council on Tuesday, do not provide a funding mechanism for roads in Clarksburg Town Center.

WASHINGTON COUNTY

County water and sewer rates, landfill fees and plan-review costs going up

April 19, 2011
Herald-Mail

County water and sewer rates, landfill fees and plan-review costs will all increase July 1, under hikes approved Tuesday by the Washington County Board of County Commissioners. The water and sewer rate increases were approved by a 4-0 vote, while the landfill fee increases and new plan-review fees were each approved 3-1, with Commissioner William B. McKinley opposed. Commissioner John F. Barr was absent for all three votes.

NATIONAL

New-home construction jumps 7.2 pct. in March as spring buying season begins

April 19, 2011
Washington Post

Builders broke ground on more new homes last month, giving the weak housing market a slight boost at the start of the spring buying season. Home construction rose 7.2 percent in March from February to a seasonally adjusted 549,000 units, the Commerce Department said Tuesday. Building permits, an indicator of future construction, rose 11.2 percent after hitting a five-decade low in February. Still, the building pace is far below the 1.2 million units a year that economists consider healthy. And March’s improvement came after construction fell in February to its second-lowest level on records dating back more than a half-century.

Study: Bay cleanup plan would be costly for Maryland

April 18, 2011
Baltimore Business Journal

A study released Monday says Maryland’s and the Environmental Protection Agency’s plan to clean up the Chesapeake Bay under new federal regulations would result in a significant hit to the state’s economy. The cost to clean up the Bay would be $9,750 per state household and Maryland’s economy will shrink by $10 billion, the study says. In addition, the plan would cost the state 65,000 jobs and more than $11 billion by 2017, the report says. The plan to clean up the bay is expected to cost roughly $11 billion.

O’Malley launches study of septic growth curbs

April 18, 2011
Baltimore Sun

Gov. Martin O’Malley created a task force Monday to study curbing pollution of the Chesapeake Bay from septic systems, saying he hoped it would help overcome concerns about the legislation he pushed unsuccessfully this year that would have banned large housing developments relying on the waste treatment systems. “We must find a way to grow in a cleaner, greener, more sustainable way,” O’Malley said before signing an executive order establishing the task force. He held the signing ceremony at the Arlington Echo Outdoor Education Center on the Severn River, where he said household septic systems account for almost 30 percent of the nitrogen fouling the bay tributary.

It was nine months ago that we launched the MacRo Report Blog to discuss topics relating to land, commercial real estate, industrial property, apartments and the housing market.  We also kept a sharp eye on local government actions that could impact the value of real estate for sale or for lease.

This happens to be our 185^th post, all of which were found by our readers on the web through various links including Facebook, Twitter, LinkedIn, The Tentacle.com, Want2Dish?, and a number of bloggers who picked us up around the globe.  We’ve received hundreds of comments – both positive and negative through all these channels.

We’ve established a readership base of over three thousand loyalists who receive our weekly Thursday update … and we always looking for more so sign up today!

As a year-end review, we thought we’d share nine of our most active posts that put focus on the land, commercial real estate, industrial property, the housing market, land development and building lots:

1. Time to Lower Real Estate Taxes and Consolidate City, County Governments? 
2. Seeking a “Normal” Real Estate Market: Using Housing as the Barometer
3.  Industrial Real Estate Market Update 
4. 6 Planning Assets that Build a Local Economy 
5. Adding Insult to Injury: Selling Commercial Real Estate in a Down Market 
6. Residential Real Estate’s Future: For Better or Worse?
7. Commercial Real Estate Market Update: Neighborhood Shopping Centers
8. Saving Farmland with Transferable Development Rights
9. 4 Sectors of Land and Commercial Real Estate: a MacRo Outlook

The blog has hosted nine terrific guest writers, for which we are very grateful.  Have you noticed, it’s all about the NINES?  Many thanks to:

1. Donavon Corum, RLA, AICP, and LEED AP, Managing Member of Design Core Studio, LLC, a Maryland Planning and Landscape Architecture Firm.
2. Thomas E. Lynch, III, Esq., principal of Miles & Stockbridge, P.A.
3. Jennifer P. Dougherty, former Mayor of the City of Frederick (2001-2005) and owner/operator of Magoo’s Pub and Eatery
4. Michael P. Pugh, Certified General Real Estate Appraiser with the Pugh Real Estate Group, LLC.
5. David Wilkinson, Vice President, MacRo, Ltd.
6. Bruce Bigelow, Senior Partner at Charitable Development Consulting
7. Paul Steckel, CPA and tax partner with McLean Koehler Sparks & Hammond
8. Jeremy Holder, President of the Land Use Council of the Frederick County Builders Association, and Vice President of Development with Ausherman Development Corporation II.
9. Steven P. O’Farrell, MAI Appraiser and Vice President of William G. Bowen, Inc.

We look forward to a bright and exciting 2011, and wish you all the best as we close out 2010!

The author: Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland.  He also writes for TheTentacle.com and Want2Dish.com

If you have not had a chance to view this 60 Minutes segment that was aired last Sunday, you might want take the time.

(CBS) By now, just about everyone in the country is aware of the federal deficit problem, but you should know that there is another financial crisis looming involving state and local governments.

It has gotten much less attention because each state has a slightly different story. But in the two years, since the “great recession” wrecked their economies and shriveled their income, the states have collectively spent nearly a half a trillion dollars more than they collected in taxes. There is also a trillion dollar hole iln their public pension funds … Click on the video below to watch!

How the Land Development Community can help to Preserve Farmland.

Last week the new Frederick County Board of County Commissioners wrapped up its strategic planning session and out of that they made farmland preservation one of their top priorities.   Since then several questions have come my way regarding my thoughts on implementing a county-wide TDR program. 

Over the years MacRo, Ltd. has actively participated in and transacted a vast number farmland preservation easements and is a strong believer that such efforts should be part of any county or jurisdiction’s planning and zoning tool box.   So with a bit of experience under my belt, I thought I’d pontificate on this topic!

For those of you who don’t know, TDR stands for Transferable Development Rights. Simply put, these are typically programs that are designed by local government to allow for the free market transfer of subdivision or development rights from a rural (agricultural and/or conservation) zone to a designated development zone within a jurisdiction.  These rights are purchased by a land developer at market value from a landowner in a rural area where there are often more development rights than are allowed to be used by zoning in that area.  Referred to as a “Sending” zone, the rights are then legally separated from the farm or rural property in exchange for a land preservation easement.  The rights can be held for investment or transferred into a “Receiving” zone, which is a designated growth area for real estate development.  In these Receiving zones additional density is allowed to be added when the rights are acquired from the rural Sending zones. 

For example, let’s say that Farmer Bob owns a 200 acre property with 30 development rights, and Land Developer Lennie has a property near the city that allows for 20 housing units.  Bob’s farm is in a Sending zone, and Lennie’s land is located in a Receiving zone.  Lennie bought the property because he knows that he can increase the density from 20 lots to 50 lots, if he can acquire 30 TDRs from a tract of real estate in the Sending zone of his community.  Broker Earl connects the two, and Bob agrees that at a fair market price he will sell Lennie his 30 development rights. They enter into a contract and inform the county government that the transaction will take place.  Bob then enters into a long term (often permanent) agreement with the County — known as an preservation easement — committing that the property will not be developed.  Once completed Lennie is allowed to increase the density of his housing project to 50 units.  

That’s a simple explanation of how it works.  The benefit of a TDR program verses a government Purchase Development Rights (PDR) program is that the dollars for a PDR program is often funded through various forms of government taxation or financing guarantees, and the former is paid for through the private sector. 

The more complex part of the TDR structure is the process of defining the Sending and Receiving areas, as well as establishing how the base development rights will be distributed.  Through the many programs that I have studied over the years, it is clear that each program is always customized to fit the specific goals and objectives of the governmental jurisdiction.  Some programs allow the real estate developer, who acquires the TDRs, to increase density only in residential areas.  Other programs use TDRs to gain approvals for subdivision plats or building permits.  There are also programs that use TDRs to increase the amount of square feet in commercial, office and/or  industrial real estate projects.

Once the program is in place, the value of a development right should be a function of free market supply and demand.  I say should be because there are several cases where the local government has to step in with price caps, floors or subsidies so as to stimulate or control the market.  In those cases this usually means that the program was flawed from the inception, causing an increase in the cost of government to support the program.  As a matter of fact one study that was conducted several years ago revealed that nearly 95% of the TDR programs that have been established by local governments throughout the country have been unsuccessful.

The key is to make sure the program is structured properly so that values will ebb and flow with the fluctuations if the real estate market, and the government does not have to use its funds in the farm and land preservation effort.

In Maryland there are active Transferable Development Right preservation programs in Charles, Calvert, Saint Mary’s, Queen Anne’s, Howard and Montgomery Counties.  Many TDR purists do not include Howard’s successful preservation program on this list, but that is another story.

In the case of Montgomery County, over 30 years ago the county appointed a task force to look into idea on how to stem the rate of loss of farmland in its rural zone.  The task force considered strengthening its zoning, funding a PDR program, and/or a TDR program. Interestingly, they also believed that the adoption of a more restrictive zoning would not provide a means of fairly compensating the landowners in those rural zone. In the end they concluded that PDR was too expensive. As a result, the group recommended a blend of the creation of an overlay agricultural protection zone (called the Rural Density Transfer – RDT – zone) that established transferable development rights for the landowners to sell in exchange for preservation easements.  The program was adopted in 1980.

The Montgomery County TDR program has become a model that a number of jurisdictions across the county have followed, but in each case they have been customized.

In subsequent articles of this series, I’ll touch on the essential elements of a successful program and TDR values, as well as the many pitfalls found in unsuccessful transferable development right programs … so stay tuned!

The author: Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland.  He also writes for TheTentacle.com.

The MacRo Report Blog features some tax insight from guest writer Paul Steckel, CPA

So you purchased some investment real estate during the “good times”. 

Now you may have noticed that the times are not so good anymore.  The value of your property may now be less than you paid for it. 

Hopefully you have the “Staying Power” to cover the carry costs of the property until the markets turn bullish.  If not, you may be looking at more than a haircut on your investment; you could be also looking at an income tax liability.

Most real estate investments are organized as tax partnerships, so the income taxation of partnerships and partners could be relevant to your situation. 

Say you bought the property for $1million in year one using $200, 000 of equity and $800,000 of debt.  In years two through four the property increased in value by $200,000 to $1.2million. 

In year four you refinanced the loan for $1million, taking out an extra $200,000 in loan proceeds to acquire a piece of commercial real estate for sale (There are complex rules regarding the treatment of interest paid on debt financed distributions, which I won’t go into). 

In the meantime, using IRS rules, you have been depreciating the property and have claimed a total of $100,000 in income tax deductions from years one through four. 

Now it is year five and due to a serious down turn in the real estate market, the value dropped back to $1million.  Things are not going as well as hoped in your ability to continue to cover the debt load, maintenance and taxes on the property; so you have made the difficult decision to sell it.

You figure if you can sell the property for $1million, you’d have enough proceeds to just about pay off the loan and essentially break even, right?  Wrong.  You have taxable income of $100,000 due to the and, accordingly; your tax could be as much as $40,000.

Why?  Both the depreciation deductions and the debt financed distributions were not taxable in the year they were taken because you had basis in the debt securing the property. 

Now that the debt is paid off, the chickens come home to roost.  The $100,000 in depreciation deduction and the $200,000 cash distribution reduced your tax basis.  That $300,000 effectively took back your $200,000 investment and created a negative capital account of $100,000.  As a result, you have $100,000 less basis in the debt than its pay off amount.  That’s taxable in the year the debt is paid off.

Paul Steckel directs the tax practice for the Frederick, Maryland office of  McLean Koehler Sparks & Hammond , which provides business and individual tax planning and preparation, estate, succession and personal financial planning. He is a CPA and Tax Partner with  the firm. Paul is a graduate of Gettysburg College.

This is an edited version of a post in the Tentacle.com dated July 26, 2010 by Rocky Mackintosh 

One of the below the fold front page headlines in the Frederick News-Post last week was an article that caught my eye:  “City considering new tax options.”  Seems that a couple of the Frederick City Aldermen threw out some “preliminary ideas, including a hotel/motel tax, a property recordation tax and an excise tax on construction … to raise tax revenue for the City” according to Patti Borda’s article of July 20^th. 

Of late I have been a big fan new Mayor and Board of Aldermen and the general direction that they have been going in the area of fiscal responsibility.  I am also very impressed with the fact that they continue to support the efforts of Gabrielle Dunn’s Land Management Code (LMC) Workgroup Committee to unravel some of the inconsistencies and unrealistic expectations found in that 700 plus page manual.  Many of the suggestions, if addressed properly, will aid in spurring on economic development, which is the true catalyst to increase tax revenue.

These movements to revise portions of the LMC are more than commendable.  But these initiatives by the City stand in stark contrast to the efforts that our current Board of Frederick County Commissioners has taken in continuing to tighten the screws on all aspects of stimulating economic development through real estate.

While I know that county and municipal operational budgets are very tight right now, and significant cuts have been made in staffing and elsewhere, elected officials always seem to gravitate to the idea of imposing more taxes and fees on the use of, transfer of, or construction upon real estate.

The MacRo Report Blog posted on July 1, 2010, an article entitled “Seeking a ‘Normal’ Real Estate Market: Using Housing as the Barometer”.  It offers a  graph displaying the boom and bust cycles of the housing industry since 1890.  The startling part is to look at the size of the latest spike and its subsequent fall compared to all previous cycles.  The point that’s clear is that while there has been much talk about the recession being over and certain elements of the residential market “finding its bottom,” most segments still have a long way to go to a true recovery… especially with commercial, retail and industrial real estate. 

With all that said, when I see that elected officials talk about imposing more taxes on a beaten industry like real estate, I have to ask … “What ARE they thinking?” 

The News-Post referenced three “new tax options”:  First, a hotel/motel tax on a local industry is not doing well.  Secondly, an increase in the real estate property transfer tax which in Frederick County is already has one of the highest rates in the state.  And the final one is to place an excise tax on new construction.  Each new tax is like laying more straws on the proverbial camel’s back of a beleaguered industry.

So, what is our City government (and County government for that matter) to do about finding revenue?  While I truly applaud our Aldermen for the very thorough approach they took in dissecting and slicing the City budget this past year, but trying to help the revenue side of the equation with just another tax on real estate is no longer the answer. 

In recent blog posts I have suggested the out of the box approach of combing inter-government related services as a means to resolving budgetary woes, and even go as far as suggesting merging the City and County Government — published in the News-Post on May 16^th entitled “Time to Lower Real Estate Taxes and Consolidate City, County Governments?”.

Now some have said the ideas go too far.  But why not look at the idea of these two huge tax eating machines coming together to combine certain overlapping services? There are so many!  This is not about cutting government services.  That is for another discussion. 

So why hasn’t at least one of the elected officials from the City or the County even thrown the idea out to start a conversation?  Could it be the fact that there is animosity between the two jurisdictions?  Or are our respective fathers and mothers concerned about holding on the sacred turf over which they rule?  Or is rocking the boat just not their thing?

Whatever the answer, these are truly unconventional times in all sectors of government and the economy.  And it’s time for our leaders to find real courage to break the mold of tradition and think out of the box … even if it means taking a risk that could challenge their incumbency.  While I am optimistic about the future, I am also realistic that our current economic situation is not going to change overnight. 

So I challenge just one of our elected officials from either camp to step up and push the envelop!  You might be surprised where it goes … and you may be startled find out what true leadership is all about!

The author: Rocky Mackintosh, President, MacRo, Ltd., a Land and Commercial Real Estate firm based in Frederick, Maryland