Monitoring the Impact of Proposed Tax Changes on Real Estate Ownership
May 11, 2021
By Joseph Rubin and Kenneth Weissenberg
On the campaign trail, President Biden made a number of suggestions for modifying the IRS Tax Code (the “Code”), many of which, if enacted, would have significant impact on real estate investing. In his first 100 days in office those changes have crystalized into specific legislative proposals as part of the American Jobs Plan and the American Families Plan. The American Jobs Plan focuses on rebuilding the nation’s physical and social infrastructure, and would be partially paid for by increasing corporate tax rates. The American Family Plan addresses education, nutrition, and direct payments and tax cuts to families with children. This initiative would be partially funded through a host of changes to individual taxes.
It is likely that these proposals will be negotiated in Congress and actual law will vary from the White House plans. Nonetheless, if enacted, the Code modifications would significantly alter the economics of public and private real estate investing. Accordingly, real estate owner-operators must understand these proposals as they move through the legislative process and how they would influence capital flows, real estate valuations and tax strategies.
As mentioned, the tax portion of the American Jobs Plan primarily deals with increases in corporate taxes. Since most real estate is held in family businesses or pass-through entities, the corporate tax rate would not impact those investors owning property through these non-corporate entities. However, the proposals in the American Families Plan relate to individual taxation; many of these changes are inter-related and, together, could result in substantially higher taxes, lower after-tax yields, reduced retirement savings, and less capital preservation for heirs. Below is a summary of the most impactful proposals.
PROPOSED TAX CODE CHANGES
The American Families Plan would create parity between earned income and investment income, including dividends and capital gains, for households with earnings greater than $1 million. Additionally, the top income tax rate for those earners would be raised from 37% to 39.6%. As such, the proposal would double the long-term capital gains rate from the current 20% to almost 40%, not including the existing Net Investment Income tax of 3.8% and any state taxes payable. In current law, capital gains taxes are triggered by a sale, and the realization of proceeds from that sale can fund the tax bill. For tax payers still alive that rule remains. However, the Families Plan also provides that when an asset owner dies, the date of death is considered the date of sale, and taxes on any unrealized gains are due and payable at that time (see also Estate Taxes below). That means taxes would be due by the surviving spouse or children without the benefit of sale proceeds and may force a sale of the property. Moreover, if the asset has been held by a family for many years, the tax basis would likely be very low compared to the property’s current market value, meaning that even if the property was sold, most of the net proceeds would be gain and taxed, leaving little funds available to the family. For leveraged properties, there are many scenarios where the taxes would be higher than the sales proceeds of the property, meaning the family would have to fund the taxes through additional sales, potentially creating a domino effect that depletes the decedent’s assets.
Many real estate investment vehicles are sponsored by a general partner or managing member, depending on the legal form of the entity, that is entitled to a share of the profits associated with the investment based on certain performance hurdles. This share of the profit is often referred to as the sponsor’s carried interest or “promote.” Currently, promotes in real estate partnerships are generally taxed at the long-term capital gains tax rate. The proposal would treat promote interests as ordinary income without regard to the proposed change to the capital gains rate discussed above. As a result, the sponsors would receive less net profits, possibly reducing their incentive to aggregate capital to invest in improving real properties.
Net Investment Income
The American Families Plan would also close what are considered loopholes in the payment of the 3.8% Net Investment Income (NII)/Supplemental Medicare Tax. The exclusion for “Real Estate Professionals,” as defined in the Code, from the NII on their share of rental income or capital gains on the sale of property in which they materially participate would be eliminated.
The like-kind exchange rules codified in IRC Sec. 1031 of the Code allow the deferral of capital gains upon the sale of a property as long as the proceeds are used to buy another property for equal or greater value. The replacement property must be identified within 45 days of the sale and purchased within 180 days. Of course, there are many complexities to these rules (see The Basics of 1031s). While like-kind exchanges were first entered into the Code in 1921, in the last ten years some members of Congress have advocated the repeal of IRC Sec. 1031. In fact, as part of the Tax Cuts and Jobs Act of 2017 (the “2017 Tax Act”), like-kind exchanges were indeed repealed for all asset classes except investment real estate. The American Family Plan partially repeals the remainder of IRC Sec. 1031, limiting the amount of the gains deferral to $500,000. That is, if the capital gain on the sale of property exceeds $500,000, the excess gains would be currently taxable at the new higher individual income tax rate.
In combination, increased capital gains tax rates and the partial repeal of the like-kind exchange rules would reduce the capital available for future investments in real estate. An example: A real estate investor buys a small apartment building for $3 million and sells the property in ten years for $7 million. To keep things simple, let’s say the investor’s tax basis was reduced through depreciation and distributions to $2 million at the time of the sale. The gain on sale would then be $5 million. Currently, the investor could pay a gains tax of $1 million (20% of $5 million) and use the $6 million in net proceeds for other investments. Or the investor could roll the entire sales proceeds of $7 million into a like-kind exchange (the purchase of another real estate asset) and the payment of gains tax would be deferred until the investor sells the replacement property. Under the current proposal, the gains tax would be $2.2 million (43.4% of $5 million) or the investor could defer $500,000 of the gains through a like-kind exchange. In that case, the investor would put the $500,000 into a new deal, pay federal gains taxes of almost $2 million and take home the remaining $4.5 million. (See also Like-Kind Exchanges Preserve Capital for Property Development and Improvement.)
It should also be noted that there are additional avenues to defer capital gains tax that would receive more attention if any single one or a combination of these proposed tax changes were enacted. One that has achieved increasing popularity is the Qualified Opportunity Zone (QOZ), created in the 2017 Tax Act. By investing the gains from the sale of property directly in a QOZ asset or a Qualified Opportunity Fund, the tax would be deferred until 2026 and the tax basis in the investment stepped-up to fair market value at the time of sale if the investment is held for ten years or longer. Neither of the current White House plans mention QOZs; however, the Biden Administration has discussed adding reporting requirements demonstrating the economic impact of the investment on the community.
The American Families Plan also suggests major changes to the way estates treat capital gains. Currently, the value of assets in the estate, including investment property, is “stepped-up” to fair market value at the real estate investor’s date of death. In that way the heirs do not have to pay capital gains tax on the capital appreciation of the decedent’s assets. If the Families Plan is enacted, this step-up would be eliminated for gains in excess of $1 million ($2.5 million for couples when also considering the existing exemption for their primary residence). The rescinding of the step-up provisions would not apply to family businesses and farms where the family heirs continue to run the business. Family-owned real estate companies that pass to the next generation may be carved out as qualifying for this exemption.
Recalling from above that under the proposed changes to the capital gains rules those gains would be realized and due upon the investor’s death, the heirs would have to immediately pay gains taxes on appreciated property above the $1 million limit. Furthermore, the heirs would not have the option of selling the properties and rolling the proceeds into a like-kind exchange to defer the payment of tax on this deemed gain. To pay the tax, heirs may be forced to sell inherited properties in potentially adverse market conditions, and may not realize the full value of development projects or transitional investments. Refinancing the properties to draw additional funds, if available, may expose the family to the risk of a real estate downturn. Neither of these options provides continuing capital for the maintenance and improvement of the assets.
The briefly worded estate tax provisions of the American Families Plan are preliminary and create as many questions as they answer: whether the income tax paid on these deemed gains will be a deduction against the estate subject to tax or the gain will be adjusted for the estate tax attributable to the assets; whether the tax on these deemed gains would be payable on assets passing to surviving spouses; etc…. There are several other proposals floating in Congress to change the estate and gift tax rules. We will continue to monitor developments in this area. One thing is for certain: With any change to the tax law, existing planning will need to be reviewed and potentially modified.
Qualified Business Income Deduction (QBID)
The QBID deduction, also created by the 2017 Tax Act, allows non-corporate taxpayers to deduct up to 20% of their qualified business income (QBI), and up to 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, depending upon the income bracket of the taxpayer. These rules, which attempted to create parity between the then newly lowered corporate tax rates and rates paid by individuals investing in pass-through entities, often apply to the many real estate investors owning property through a pass-through entity or REIT structure. While fairly new, during his campaign, President Biden campaign had raised the possibility of phasing out the QBI deduction. However, this change was not in the American Families Plan. It is possible that the size of the deduction may change if new corporate tax rates are enacted.
COMPREHENSIVE TAX CHANGES REQUIRE CAREFUL MONITORING
None of the proposed changes are law. They will be debated in Congress and it is unclear what or when new laws will emerge. If enacted as proposed, the tax changes will have a profound impact on real estate capital flows, as well as the preservation of asset values of small business owners, long-term real estate investors, and their families. Accordingly, real estate and private business owners should carefully monitor these developments and be in frequent consultation with their tax advisors.