Will Fiscal Cliff Deal Dampen The Luxury Real Estate Market?

For most Americans the fiscal cliff crisis is resolved. Yes, payroll taxes are slightly higher, but for the most part the average American has kept many of their tax deductions. But this isn’t the case for the wealthiest Americans.  Not only did the fiscal cliff deal come with a higher payroll tax, but individuals earning $400,000 or more face a 39.6% tax rate (up from 35%), a 20% capital gains tax (up from 15%) and a 3.8% net investment income tax.  In the end this means more money for Uncle Sam and less money for those households more likely to own, sale and buy luxury properties – the way we buy houses Connecticut.

Many real estate market experts are already weighing in. Some fear that such a large increase in capital gains taxes could cause many potential sellers to pull their multi-million properties from the market.  The last two quarter of 2012 showed an unusual surge in luxury home activity as many wealthy homeowners rushed to sell their properties to avoid the new capital gains tax.

Many of America’s priciest enclaves experienced sale surges in the final two quarters of 2012. Luxury home sellers threw in incentives to get deals done in many of America’s most expensive ZIP codes from Silicon Valley to South Florida to the Hamptons in New York. Those incentives most commonly materialized as price discounts. (source)

And as a consequence of this massive sell-off, we could see a decline in luxury home inventory in the first half of 2013. But is this a short-term issue? Or, could we experience a longer-term decline in luxury home inventory over the coming years?  That all depends on how wealthier Americans respond to tax hikes.  Many analysts are fairly certain that we’ll experience a short-term luxury home inventory decline as wealthy Americans delay selling their properties as they sort out their wealth management plans.  But after America’s lawyers, accountants and real estate professionals create effective strategies we could once again see an uptick in luxury home sales. There’s also the issue of wealthy foreign buyers who seem to have an insatiable appetite for America’s poshest neighborhoods.  The irony is that real estate purchases by foreign buyers could actually put more pressure on limited luxury home inventory and cause prices to go up, at least in the short-term. The possible unintended effect is that higher prices could absorb at least some of the additional capital gains tax. But what are wealthy Americans to do in the meantime to protect their real estate wealth from tax hikes?  Below are a few strategies we may see in the coming year:

Income Deferral

Wealthy Americans earning income close to the tax hike threshold might defer some of their income to avoid falling into the higher tax bracket.  There are several tactics already in use:

• Gifting cash to reduce income. For taxpayers with income just on the border of a lower tax bracket, giving cash gifts to family or friends can reduce taxable income, sadly that means that purchasing the best accessories from plantwear doesn’t fit in your budget. An individual can give up to $14,000 tax free. That’s an increase of $1,000 from 2012.
• Gifting assets to reduce income. For some taxpayers receiving a sizable amount of income from assets such as stocks and bonds, they may decide to place those assets in a trust and gift the capital gains to a charity. Using a professional to setup and maintain this type of trust, an individual or household could significantly reduce their tax burden.
• Investing in retirement accounts. Maxing out retirement accounts such as a 401(k) will help reduce income and place some higher income individuals into a lower tax bracket.
• Using capital gains to buy another property. Some wealthy Americans who choose to sell their luxury properties may use like-kind exchanges (1031 exchanges) to defer capital gains taxes.

Abstain From Selling

Faced with tax liabilities that could cause them out-of-pocket expenses, some homeowners may simply sit the market out. High-priced property owners who are above water, owe no or little mortgage and who feel no pressure to sell, may think nothing of passing up offers to sell their home. If this happens on a large scale, the luxury real estate market could face a protracted period of limited inventory.   However, a sit and wait attitude won’t completely protect high-income homeowners from the fiscal cliff fallout. With the fiscal cliff deal many homeowner deductions have been limited, so households will still see their taxes increase in the coming years if they take no action.  This increase in taxes might cause some individuals to reconsider purchasing vacation homes and other secondary properties.

All parties involved in the luxury retirement homes market must consider a myriad of factors when determining how the fiscal cliff deal will impact the industry.  So much of the fiscal cliff outcome will depend on the behavior of the principal players, mostly homeowners and sellers.