After five months of near misses, residential prices in San Diego finally passed up those of Seattle on the Case-Shiller Home Price Index in February 2021. Yet prices in the Central Puget Sound region were still up by more than 15 percent, and all but two cities on the index (Chicago and Las Vegas) saw double-digit year-over-year gains. Low inventory is expected to keep pushing prices higher: the National Association of Realtors reported 2.1 months in inventory across the country, 1.2 months fewer than a year before. In the Seattle metropolitan area, data from the Northwest Multiple Listing Services show that inventories tightened much further in the same period—from 1.1 months in March 2020, to 0.4 months in March 2021.
The shortage of homes for sale and its impact on prices have long been weighing on the minds of policy makers in the legislature and the governor’s office. Indeed, it may partly for this reason have been that when the state Senate narrowly passed SB 5096 enacting the state’s first capital gains tax on Sunday, 25 April, they did so without an emergency clause and with an effective date of 1 January 2022. This has provided an incentive for release of investment properties onto the market before the tax is imposed. Earlier versions of the bill exempted all residential real estate from the tax. However, except for transfers of qualified small businesses, 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. In combination with profit-taking from strong stock market returns in recent years, such entities and other residents with plans to use 1031 exchanges may wish to accelerate those transactions before the tax takes effect next year.
Home prices increase from coast to coast
The CoreLogic Case-Shiller index results published by S&P Dow Jones on 27 April showed year-over-year residential price growth rising to 15.4 percent from 14.3 percent at Seattle. San Diego prices launched ahead, vaulting to 17.0 percent from 14.3 percent in December. Home prices at other West Coast peer cities each rose by 0.8 to 1.1 percent (Charts A and B).
For a sixth month, 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, a trend that RSIR has observed locally for four years. Lazzara continued to attribute this migration to COVID-19, while holding out the possibility of structural changes in demand:
More than 30 years of S&P CoreLogic Case-Shiller data help us to put February’s results into historical context. The National Composite’s 12.0 percent gain is the highest recorded since February 2006, exactly 15 years ago, and lies comfortably in the top decile of historical performance. Housing’s strength is reflected across all 20 cities; February’s price gains in every city are above that city’s median level, and rank in the top quartile of all reports in 18 cities.
These data remain consistent with the hypothesis that COVID has encouraged potential buyers to move from urban apartments to suburban homes. This demand may represent buyers who accelerated purchases that would have happened anyway over the next several years. Alternatively, there may have been a secular change in preferences, leading to a permanent shift in the demand curve for housing. Future data will be required to analyze this question.
Provisions of the new CGT
At this writing, SB 5096 remains to be signed by Governor Inslee; but no surprises are expected, as he pushed the tax for years. The bill levies “a seven percent tax on the voluntary sale or exchange of stocks, bonds, and other capital assets where the profit is in excess of $250,000 annually.” The $250,000 basic exemption applies to both individuals and married couples or domestic partners, filing separately or jointly.
While the bill’s main targets are profits taken on financial transactions, real estate transfers do not appear to be wholly exempt. Transactions that are clearly exempt are those where real property is transferred “by deed, real estate contract, judgment, or other lawful instruments that transfer title to real property and are filed as a public record.” Interests in property held by a qualified small business for five years or more are likewise exempt. There is also a laundry list of exemptions for farmers, ranchers, cattle, livestock, harvested timber, forestlands, fallen trees, Christmas trees, commercial fishing, property condemned by the federal government, and so forth.
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:
[T]he department is not bound by the parties’ agreement as to the allocation of assets, allocation of consideration, or fair market value, if such allocations or fair market value do not reflect the fair market value of the real estate. The assessed value of the real estate for property tax purposes may be used to determine the fair market value of the real estate, if the assessed value is current as of the date of the sale or exchange of the ownership interest in the entity owning the real estate and the department determines that this method is reasonable under the circumstances.
Recent court rulings show jurists beginning to question transaction values as certain indicators of fair market value where there is a motive to limit tax exposure. This would be the case among some Section 1031 exchanges of real estate. It appears the Washington State Legislature had such exchanges in mind when amending SB 5096 for final passage.
While in the works for years, final enactment of the Washington State CGT comes amid new proposals by the Biden administration for both a 39.6 percent federal capital gains tax and a capping of Section 1031 exchanges at $500,000. Either of these controversial measures would need to pass an evenly divided Senate, which is arguably unlikely.
Capturing profits before the tax takes effect
Since its passage, there has been very little legal coverage on tax management measures in preparation for the CGT. The January 2022 effective date provides a window of opportunity to take profits before they are subject to the tax. Of course, with heightened sensitivity of the risk to Washington State’s low-tax reputation, a court challenge is also likely. If the CGT is upheld, we anticipate that stockholders, fiduciaries, and trustees will explore a variety of appraisal and legal strategies to mitigate their exposure going forward.
Dean Jones, CEO and Co-Owner of Realogics Sotheby’s International Realty, predicts that stock liquidations prior to tax’s effective date 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 a local RSIR broker.
 Note: Realogics Sotheby’s International Realty is not a registered investment, legal, or tax advisor or a broker/dealer. All remarks herein are presented in the context of real estate market analysis only and intended as educational material. You are advised to consult a qualified attorney or financial advisor before making any investment decision.
 Published by S&P Dow Jones, the Case Shiller Index surveys resales of residential homes in the Seattle MSA. The index notably does not account for condominium sales. “S&P CoreLogic Case-Shiller Index Reports 12.0% Annual Home Price Gain in February 2021,” S&P Dow Jones, New York, 27 April 2021.
 Ibid., 6(2)(iii)(c).
 Example: “The Minnesota Supreme Court questioned whether a Section 1031 exchange truly represents an arm’s-length price. The Court noted that this unique type of transaction provides certain tax benefits that enable property owners to defer the recognition of capital gains or losses. But the record evidence lacked any information indicating the motivations of the buyer and to what extent the transaction price was impacted by market forces versus tax-savings motives. Absent evidence indicating that the Section 1031 exchange was at market levels, the Court could not conclude the Tax Court properly relied on the transaction to determine the market value of the property.” Faegre Drinker Biddle & Reath LLP, “Minnesota Supreme Court Rejects Section 1031 Exchange as Evidence of Property’s Value,” 4 March 2020.
 Laura Davison and Allyson Versprille, “Biden Eyeing Tax Rate as High as 43.4% in Next Economic Package,” Bloomberg, 22 April 2021; Emily Cadman, “Biden Targets $41 Billion Tax Break for Rich Real Estate Investors,” Bloomberg, 28 April 2021.