The following excerpt is from the current edition of Tax Benefits of Ownership, which gives an overview and explanation of the roles of inflation and appreciation on tax revenues and profit during the ownership and sale of a property.

Uncle Sam creates his share — mostly 

Consider an investor who decides to sell an improved parcel of real estate they bought 21 years ago for $440,000. The investor’s broker locates a buyer willing to pay $1,000,000 for the property. The seller’s net sales price will be $900,000 ($1,000,000 minus $100,000 in transactional expenses).

During their ownership of the property, the investor took $140,000 in depreciation deductions. Consequently, the investor’s adjusted basis in the property is $300,000 ($440,000 original cost basis minus $140,000 depreciation).

The investor does not plan to reinvest the net sales proceeds by acquiring replacement property in a §1031 reinvestment plan.

The investor’s agent reviewing a seller’s net sheet with the investor informs the investor their net profit on the sale will be $600,000 ($900,000 net sales price minus $300,000 adjusted cost basis). The investor’s profit comprises:

  • $140,000 in unrecaptured gains due to depreciation deductions, taxed at ordinary income rates limited to a ceiling of 25%; and
  • $460,000 in long-term capital gains due to an increase in the property’s dollar value, taxed at capital gains bracket rates of 0%, 15% and 20%.

The broker’s analysis of the sales tax consequences does not consider the monetary inflation that has taken place in the past 21 years and is reflected in the property’s price increase — and thus the profit.

When consumer inflation of the dollar is taken into consideration, the purchasing power of the investor’s property value and net operating income has remained, in real terms, unchanged over the 21-year period of ownership.

Changes in the general price level are measured and indexed as a figure by the Bureau of Labor Statistics. The Bureau reports the figures periodically for several metropolitan regions as the Consumer Price Index (CPI). The CPI measures and tracks the rate of consumer inflation. CPI is simply an index of fluctuations in the general price of a huge selection of consumable products — a “basket of goods and services.”

The CPI is published nationally and regionally; however, the most relevant index is regional. There are three regional indexes for California: Los Angeles-Long Beach, San Francisco-Oakland and San Diego. Regional indices reflect local economic pressures affecting retail pricing.

The CPI doubled during the investor’s 21-year holding period. Thus, a dollar held on the date they bought the property has only about half its purchasing power today. Put another way, over 21 years it takes twice as many dollars to purchase the same amount of land, labor, and materials to produce the property the investor is now selling.

The demographic and cultural conditions which affect the property’s value may not have changed — but the dollar has.

The investor believes it is unfair to pay tax on their receipt of inflated dollars from a sale — especially since the dollar’s value has decreased due to the monetary policy of the very government doing the taxing.

The investor claims the taxes need to be based on real economic gain — the nominal sales price today less the inflation-adjusted cost basis — to bring the two figures into conformity with the worth of the dollar today. The adjustment eliminates the effects of federally induced monetary inflation over the period since the investor’s acquisition of the property.

The property is located in Riverside County, so the investor calculates their real profit (adjusted for inflation) by using the same CPI figures for Los Angeles the investor uses to adjust the rents they charge tenants. The calculation is:

  • 9 (Current CPI)
  • 45 (Original CPI at time of purchase 21 years ago)
  • X $440,000 (Original purchase price)
  • = $880,000 (Original purchase price in today’s dollars)

Thus, $440,000 of the current net sales price is created solely by price inflation. Due to a lack of local demographic changes other than wages running parallel with inflation, the appreciation factor has added nothing to the nominal dollar value of the property while consumer inflation alone has altered its dollar value.

On closing, the investor reports the profit on the sale — using inflation-adjusted figures — as $300,000 ($900,000 resale price minus $600,000, the remaining cost basis of $300,000 adjusted for inflation).

The IRS disagrees and claims the profit is $600,000 ($900,000 resale minus the nominal $300,000 remaining cost basis).

Does the investor owe capital gain taxes on the $440,000 portion of the net sales proceeds which consists solely of inflated dollars?

Yes! Taxes are based on nominal profit, calculated as the actual dollars of capital invested in the property subtracted from the net sales price of actual dollars received on the sale of the property. The real profit (after inflation adjustments) received by the investor on the original investment is of no concern to the government. However, the real profit is of concern to a prudent investor and their broker when determining the time to sell during an economic business cycle. [Hellerman v. Commissioner (1981) 77 TC 1361]

Fluctuation in the price level of goods and services

Inflation is the rise in general price levels of everything people buy. Inflation consists of two categories:

  • consumer price inflation; and
  • asset price inflation.

Although the two categories of inflation are intertwined with the dollar (and California real estate is a US dollar denominated asset), their differences are significant.

Consumer price inflation is an increase in the general price level of all consumable goods and services in the economy. Simply, the rate of consumer price inflation is set by the rise in price of everything we buy to consume.

While the category of consumable goods includes rent movement in housing, it does not include the price movement of the underlying asset — the housing itself. Home improvements are not consumed, only used, while remaining intact. Land and improvements are directly correlated to savings — a store of wealth in the ownership of a home. A property’s resale value is not associated with day-to-day expenditures for consumable goods or services while the rental value of the property is.

The Consumer Price Index (CPI) does not measure asset inflation. Asset prices behave quite differently and independently from factors driving consumer price movement. Assets are investments, with pricing based on the capitalization rate applied to the likelihood of a return on the investment. These are an investor’s expectations, not a consumer’s. For investors, inflation relates to the future price of the investment; for consumers, inflation is today’s changes in the price of goods and the wages they earn to buy them.

Inflation and the taxes sellers pay on sales 

The government’s need to raise revenue through a system for taxation of income and profits that does not respond well to inflation. When inflation occurs and investors take profits, they need to pay taxes on any profit created by the inflated dollars the investor accepts at the time of sale.

Thus, investors pay taxes on the nominal dollar amount of inflation-generated profit. Profit taxes are not calculated on the actual economic value received which reflects the real profit.

There are two reasons the tax system largely ignores inflation.

First, the U.S. dollar’s primary function is to act as a uniform medium of exchange, or the dollar’s “legal value.” The dollar is the unit of exchange the U.S. has established to pay all public and private debts, including the payment of taxes. [Norman v. Baltimore & O. R. Co. (1935) 294 US 240]

As a medium of exchange, inflated dollars affect everybody, everywhere who sets prices for goods in US dollars. Not only do we receive inflated dollars for services, but we pay for services with inflated dollars. Therefore, an investor who sells property and receives inflated dollars as their price pays taxes with inflated dollars (from net sales proceeds).  The adverse impact of inflated values is diminished since the investor pays their taxes with inflated dollars.

Also, during the time the investor holds the property, rents typically increase to cover the landlord’s inflated cost of operations and earnings on increased property value. Greater amounts of rent for the same property can only be successfully demanded when wages and salaries increase.

In a loopback, consumer inflation is met by consumers demanding higher wages and salaries, usually at or above the rate of consumer inflation, the COLA pay raise. Recall that rent amounts paid for housing are part of the calculation setting the rate of consumer inflation. Inflated rents in turn set the value of the rental property (based on the current capitalization rate for like investments which always includes an inflation premium added to the base real rate of return).

Second, when profit is calculated, the amount includes actual dollars received on a sale. Profit does not factor in the effect of inflation on the quantity and quality of consumables, i.e., goods and services.

For a capital gains profit to exist in a real estate transaction, more dollars are received on a sale than dollars paid to acquire and improve the property. In this sense, the capital gains tax takes a portion of only the increase in actual dollars received. Yet, when the inherent value of the real estate declines due to physical deterioration or obsolescence, the property’s value in current dollars may fail to keep up with consumer inflation. In terms of real value, the property’s dollar value has fallen when the dollar amount of inflation since acquisition is backed out of the property’s current market value.

For example, an investor bought a property 20 years ago for $440,000. What if the current resale price for the property is $500,000 — an 11% nominal increase in dollars?

Here, the investor has a capital gain of $60,000 – the 11% increase in value.

However, under the real profit analysis, our investor has an inflation-adjusted loss of $180,000 ($500,000 resale minus $580,000, the investor’s inflation-adjusted price on acquisition).

Editor’s note — For the property to maintain its original purchasing power of $440,000, the investor would have to net $880,000 on resale — after the payment of their capital gain profit tax.

Can the investor report a loss on the sale?

No! The profit is again measured in actual dollars received, even though the real estate’s price (and its basis) has not kept pace with inflation. [Spurgeon v. Franchise Tax Board (1984) 160 CA3d 524]

This applies to both state and federal taxes. California definitions of income and profit are the same as federal definitions. [Calhoun v. Franchise Tax Board (1978) 20 C3d 881]

Losses due to inflation and cost basis reduction through depreciation deductions are subject to the same rules — the use of actual dollars paid and received, without any adjustment for inflation.

Cutting its share 

The government awards itself a share of an investor’s real estate value, payable on any resale of the property at a price greater than the investor’s remaining cost basis — in the form of capital gain taxes.

To understand how “government equity sharing” works, it is important to recognize the economic fact that, everything else remaining constant (like cap rates, which don’t), improved real estate tends to follow inflation trends over time as rents tend to rise at the rate of inflation (as do salaries to pay the rent). Thus, the earning power of improved, income-producing real estate typically remains constant. Rents simply increase to meet (and create) inflation. Increased demographics within the local population is a factor creating property appreciation, not asset inflation. Over time, appreciation of the property’s location by the population adds to a property’s value. By definition, appreciation drives the increase in a property’s value beyond the rate of annual inflation.

When real estate values and the CPI increase at the same pace over time, the real economic value of the real estate remains constant. Due to this phenomenon, real estate is deemed a “hedge” against inflation, albeit a hedge that is taxed if the property is disposed of in a cash-out sale.

Were profits not driven by inflation, the government would not receive as much tax revenue as it now does.

For example, consider an investor who bought real estate for $500,000 20 years ago.

Today, the property’s value is $1,000,000. However, due to intervening consumer price inflation, the property is worth the same as it was 20 years ago in real terms.

When the investor sells the property for $1,000,000, they will have a $500,000 profit on property that has only maintained its original worth in dollar purchasing power. The profit taken due to price increase is classified as net long-term capital gain, currently taxed at 15% and 20%.

Thus, the government cuts itself a 7.5% to 10% share in the total current dollar value of the property due solely to a reduction in the value of the dollar (not to mention the transactional costs of a sale running in the range of 5% to 10% of a property’s gross price).

The investor is economically worse off selling the property than retaining it. This makes it difficult for agents to encourage owners to sell, unless the owner acquires like-kind replacement real estate in a §1031 exchange to exempt all profit from taxes.

Economic consequences 

Investors need to keep a close eye on long-term inflation trends and business cycle price fluctuations (from boom to bust) and maximize annual rent increases and thus property value, and on a sale, profits. It is said the three most important words in real estate are “location,” “timing” and “price.”

The timing of any sale of a property up for consideration to be sold needs to be influenced by an increase in its value through asset price inflation, which exceeds the percentage change in the CPI since acquisition. When the value increase exceeds the increase in the CPI figures, which usually occurs during a business cycle’s boom but not a recession, the investor will experience a real economic profit on the sale.

When an investor sells real estate that has not kept pace with inflation at the time of sale, they will have lost real money, but they will still be taxed on their inflation-created profit. The investor will be poorer going forward for failure to sell at the right time — at the peak of the upward phase of a business cycle.