In February 2021, after five months of close calls, San Diego's residential prices finally surpassed those of Seattle on the Case-Shiller Home Price Index. Despite this, prices in the Central Puget Sound region rose by more than 15%, and all but two cities on the index (Chicago and Las Vegas) experienced double-digit year-over-year increases. Low inventory is expected to keep pushing prices higher: the National Association of Realtors reported 2.1 months of inventory nationwide, 1.2 months less than a year ago. In the Seattle metropolitan area, data from the Northwest Multiple Listing Services show that inventories tightened even more in the same time period, from 1.1 months in March 2020 to 0.4 months in March 2021.

The lack of available housing and its impact on prices have long been on policymakers' minds in the legislature and the governor's office. Indeed, it may have been partly for this reason that the state Senate narrowly passed SB 5096 on Sunday, April 25th, enacting the state's first capital gains tax without an emergency clause and with an effective date of January 1, 2022. This has prompted the release of investment properties onto the market ahead of the tax's implementation. The tax had previously been exempted from all residential real estate in previous versions of the bill. However, conditions were added to the final version that limited the exemption of any transfer of a real estate interest by a private entity to the fair market value of that interest, except for transfers of qualified small businesses. Such entities and other residents with plans to use 1031 exchanges may wish to accelerate those transactions before the tax takes effect next year, in combination with profit-taking from strong stock market returns in recent years.

Home prices increase from coast to coast

Year-over-year residential price growth in Seattle increased to 15.4 percent from 14.3 percent, according to the CoreLogic Case-Shiller index results published by S&P Dow Jones on April 27. San Diego prices jumped to 17.0 percent in January, up from 14.3 percent in December. Other West Coast peer cities' home prices each increased by 0.8 to 1.1 percent (Charts A and B).

Craig J. Lazzara, Managing Director and Global Head of Index Investment Strategy at S&P Dow Jones Indices, reported buyers migrating from urban neighborhoods to the suburbs for the sixth month in a row, a trend that Realogics Sotheby’s International Realty has seen locally for the past four years. Lazzara continued to blame COVID-19 for the migration, but he did not rule out the possibility of structural demand changes:

We can put February's results into historical context thanks to S&P CoreLogic Case-Shiller data spanning more than 30 years. The National Composite's gain of 12.0% is the highest since February 2006, exactly 15 years ago, and puts it comfortably in the top quartile of all time. Housing's strength is reflected in all 20 cities; price increases in February were above the city's median level in every city, and in 18 cities, they ranked in the top quartile of all reports.

These findings support the theory that COVID has influenced potential buyers to relocate from city apartments to suburban homes. This demand could represent buyers who have accelerated purchases that would have taken place over the next few years anyway. Alternatively, there could have been a long-term shift in preferences, resulting in a permanent shift in the housing demand curve. To answer this question, more data will be needed in the future.

New CGT regulations

SB 5096 is to be concluded by Governor Inslee in this writing, but there will be no surprises, as he has been pushing the tax for years. The bill collects '7% tax on the voluntary exchange or sale in excess of US $250,000 per annum on stocks, bonds and other capital assets.' The basic waiver of $250,000 applies, separately or together, to both individuals and married couples or home partners.

Although profit in financial transactions is the main target of the bill, immobilization transfers do not seem totally exempt. The clearly exempt transactions include transactions in which property is transferred by “by deed, real estate contract, judgment, or other lawful instruments that transfer title to real property and are filed as a public record.” Interest in property held for five years or more by a qualified small business is also exempt. A list of exemptions is also available for farmers, farmers, ranchers, animals, cattle, timber harvested, forests, fallen trees, Christmas trees, commercial fishing, the Federal Government's property condemnation, etc.

Yet where a real estate interest is sold or exchanged by a ”privately held entity,” the exempt share of that interest is limited to “the fair market value of the real estate owned directly by the entity less its basis, at the time that the sale or exchange of the individual’s interest occurs.” Moreover, the law will allow the state Department of Revenue to determine fair market value, regardless of transaction price or any other agreed amount:

The department will not, if any such allocations or fair market value do not reflect fair value for the property, be bound by the parties' agreement to asset allocation, consideration allocation or just market value. In order to determine the fair market value of the estate, the applied value of the real estate for property tax purposes can be used, where the applied value is current on the date the interest in the real estate entity is sold or exchanged; the Department determines that the valued price is reasonable in such circumstances.

Jurists starting to question transaction values as some indicators of fair market value when there is a reason for limiting tax exposure have been shown by recent court rulings.

This is the case with some real estate exchanges in Section 1031. It seems that when modifying SB 5096, the Washington State legislature had these exchanges in mind.

During years of work, a new proposal from the Biden administration for a tax on federal capital gains of 39.6% and for a capping of Section 1031 exchanges of 500,000 dollars is the final adoption of the Washington State CGT.

An equally divided Senate would have to pass one of these controversial measures, which is probably improbable.

Profits are captured before the tax is imposed.

There has been very little legal coverage on tax management measures in preparation for the CGT since its passage. The effective date of January 2022 provides a window of opportunity to take profits before they are taxed. A court challenge is also likely, given the increased sensitivity of the risk to Washington State's low-tax reputation. If the CGT is upheld, we expect stockholders, fiduciaries, and trustees to look into a variety of appraisal and legal options to reduce their exposure in the future.

Stock liquidations prior to the tax's effective date, according to Dean Jones, CEO and Co-Owner of Realogics Sotheby's International Realty, will boost home sales this year. “The state capital gains tax is likely to drive investors to close their positions at peak stock prices in favor of real estate, especially for principal residences, while deals abound in the city and interest rates are historically low (but rising). Similarly, the region’s employees with RSUs vested this year or before may prefer to cash those out before the year end.”

For more details on the February 2021 Case-Shiller Index results, download the S&P Dow Jones Case-Shiller summary report. For details on the market implications of our reports for homes in your neighborhood, contact me.