The Latest Tax Proposals and Their Impact on Real Estate Investing
April 21, 2022
By Joseph Rubin
As Yogi Berra said, “It’s déjà vu all over again.” A year ago, we described the portion of the Biden Administration’s proposed tax plans that would have had a significant impact on the real estate industry. At the time the new administration was trying to follow through on its campaign promises to reform personal income taxes in the proposed American Families Plan. Our particular focus was the potential for significant increases in capital gains tax on appreciated real property for owner/investors and their estates through both rate changes and the repeal of like-kind exchanges. Last fall, the House Committee on Ways & Means issued a new summary of the tax proposals as part of a budget reconciliation bill. Many of the items in the Administration’s initial plan (including the capital gains proposals) were not included in this summary, and the real estate industry breathed a collective sigh of relief. After several months of negotiations, the bill did not pass in the Senate.
The Administration’s 2023 budget, as outlined in the Treasury Department’s Green Book, contains many of the same proposals that were in the American Families Plan, some with new provisions. While there does not appear to be sufficient support for these tax increases in Congress, real estate market participants should closely monitor both the progression of the proposed reforms and ongoing Congressional and White House negotiations. Aside from revenue raising, the proposal also includes additional funds and incentives to promote affordable housing and community development. This article focuses on the most current set of proposals that would impact real estate ownership and investing.
Renewed Focus on Capital Gains Taxes and Like-Kind Exchanges
As mentioned, the group of proposals in the budget plan that would likely most impact real estate market participants involves the taxation of capital gains. The Administration once again is suggesting that, beginning in 2023, the federal long-term (assets held more than one year) capital gains tax rate be brought in parity with ordinary income rates, meaning a doubling from the current rate of 23.8% to 40.8%, including the 3.8% net investment income (NII) tax, for taxpayers who file jointly with taxable income greater than $1 million. The budget also re-proposes increasing the marginal tax rate for the highest earners (here defined as $450,000 for married couples filing jointly or $400,000 for unmarried individuals) from the current 37% to 39.6%, or 43.4% with the NII tax.
While stated somewhat differently than last year, the budget also brings back the concept of incurring capital gains not only when a property is sold, but also when it is transferred through a gift, by funding a grantor trust, or upon the death of the owner (property transferred to a decedent’s spouse is exempt from recognizing the gain). A year ago, the proposal included a $1 million per person exclusion from capital gain recognition on property transferred by gift or at death. That provision appears to have been removed and replaced with a $5 million per donor exclusion from gains on appreciated assets transferred by gift during life. In other words, it seems the gains exclusion for unrealized gains in an estate has been removed.
When a gain is realized upon the death of the owner, the gains can be reported either on the estate tax return or a new capital gains return. Last year it was unclear whether the gains tax was deductible from estate taxes. The differentiation of a separate gains form could imply that it is, although it is not explicitly addressed.
In our analyses last year, we expressed concern about liquidity issues for heirs of long-term held real estate, particularly related to family businesses, where the estate may have extremely low bases in the inherited assets and therefore large unrealized gains. Currently, the basis in the assets can be stepped up to current fair market value at the time of death, and the heirs can hold or sell the assets without the burden of the gains tax. However, under the proposed scenario, the step-up in basis becomes moot and a family may have to sell the property to pay the tax. If the property is leveraged and significantly depreciated, the sale proceeds may be insufficient to cover the taxes. Moreover, by being forced to sell the properties, the heirs would then forgo ongoing income and value appreciation. The proposals do allow a 15-year fixed rate payment plan for the tax on appreciated illiquid assets transferred at death. Additionally, the rules provide for an estate to elect not to recognize unrealized gains on certain ongoing family-owned and -operated businesses.
As noted, the recognition of unrealized gains applies to transfers of assets, including interests in properties, during the owner’s lifetime. Currently, owners and investors can use grantor trusts to move ownership interests to their heirs. The owner, or “grantor,” sells the property to a grantor trust in which the heirs are beneficiaries and would benefit from the future value appreciation of the assets. That transference of assets from the grantor to the grantor trust is not currently recognized as a sale for income tax purposes (although it is recognized for estate tax). Under the proposed rules, any transfer of assets from a grantor to a grantor trust would be treated as a sale for income tax purposes and any capital gains on the assets would be taxable at the time of the transfer. Effectively, the grantor trust would be treated as a third party rather than an extension of the grantor, limiting the benefit of this estate planning strategy.
The like-kind exchange rules codified in IRC Sec. 1031 allow the deferral of capital gains upon the sale of a property if 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, since the Tax Cuts and Jobs Act of 2017 the rules only apply to real property held for productive use in a trade or business or for investment. As in the American Families Plan, the current proposals limit the deferral of capital gains on investment property to $500,000 per taxpayer ($1 million for married individuals filing a joint return). Accordingly, the potential for deferral of capital gains recognized upon sale, transfer, or death have been curtailed. In combination, increased capital gains tax rates and the partial repeal of the like-kind exchange rules would likely reduce the capital available for future investments in real estate. It should be noted that some deferral of capital gains is still available through investment in qualified opportunity zones, and there is a separate proposal in Congress to enhance the benefits to investors providing capital to underserved communities (see below).
Here is an example of the impact of these proposed rule changes that we provided last year (this hypothetical example excludes any impact of depreciation recapture): 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 can pay a gains tax of $1 million (20% of $5 million) and take home $6 million in net proceeds. 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.
The proposal would create a new name for a non-passive interest in an investment vehicle: investment services partnership interest (ISPI). Profits from a real estate venture would be more clearly bifurcated between those earned by passive investors and those earned by active investors who provide services to the investment entity (e.g., deal sourcing, asset management) and own ISPI interests in that deal. Carried interest or “promotes” are the share of the profits earned by sponsor investors holding ISPIs and providing a service to the investment entity that are predicated upon achieving certain performance hurdles. Currently those interests are taxed as capital gains. The proposal would tax income on ISPI as ordinary income if the taxpayer’s income from all sources exceeds $400,000. Those same taxpayers would also have to pay self-employment tax on ISPI income. If the taxpayer has both ISPI and passive interests in the venture (say the person holds both general partner and limited partner interests in a partnership), income from the limited partner interests would not be reclassified as ordinary income.
The House proposal last fall made an exception to taxing carried interests as ordinary income when a real estate investment was held at least three years, beginning when substantially all the capital in the investment vehicle was invested. The Green Book does not mention this three-year holding period exception.
Net Investment Income Tax
Last year’s version of the American Families Plan would have eliminated the exclusion for “real estate professionals” to pay NII tax, resulting in the requirement to pay an additional 3.8% tax on the taxpayer’s share of rental income or capital gains on the sale of property in which they materially participate. The current budget proposal is silent on this provision.
Additional Support for Affordable Housing
As we recently described in a separate article, the lack of affordable housing in the United States has significantly worsened during the pandemic. The proposed budget addresses this issue in several ways:
- The Department of Housing and Urban Development (HUD) would be allocated more than $6 billion in additional funds, a 9.4% increase over the 2022 budget
- The current New Market Tax Credits program allocates $5 billion of tax credits annually to investors in qualified community development entities (CDE) through 2025. The new budget would permanently extend the program, allowing CDEs to continue to invest in low-income communities with the certainty that the program will be maintained. The allocation would continue to be $5 billion per annum, indexed for inflation after 2026.
- More low-income tax credits (LITCH) would become available to subsidize affordable housing in targeted neighborhoods. Certain new construction and substantial rehabilitation of affordable rental properties financed by qualified private activity bonds would be eligible for additional tax credits by using a higher percentage of credits to the property’s depreciable basis (known as a “basis boost”).
- The proposed budget also allocates additional funds to several HUD initiatives including the Housing Choice Voucher Program, the HOME Investment Partnerships Program, Homeless Assistance Grants, and the Community Development Block Grant program.
Updates to Qualified Opportunity Zone Rules
While not part of the Administration’s budget proposal, it is also important to be aware of potential new legislation pertaining to qualified opportunity zones (QOZs). A bipartisan group of senators and representatives let by Senators Booker and Scott has drafted The Opportunity Zones Transparency, Extension, and Improvement Act to enhance the QOZ program and attract additional capital to underserved neighborhoods across the country. The bill contains the following provisions:
- To address instances where QOZs were established in communities which are no longer distressed, the bill would sunset the QOZ designations for areas with median family income at or above 130% of national median family income. The states would be able to designate new opportunity zones one-for-one for any eliminated designated areas.
- In recognition that the QOZ rules were issued by the Treasury Department two years after the legislation, the capital gains deferral period would be extended from December 31, 2026 to December 31, 2028. The bill also lowers the required holding period to receive the additional 5% step-up in basis from seven years to six years. This would apply a 15% reduction to gains deferred prior to December 31,2022.
- The original proposed legislation for QOZs had significant reporting requirements that were not included when the final legislation was passed in 2017. These reporting requirements would be re-established.
- To promote investments in smaller QOZs, a qualified opportunity fund could be organized as a fund-of-funds that could invest in other qualified opportunity funds focused on smaller communities or individual projects.
- The bill would create a State and Community Dynamism Fund to provide operating and technical support to high-poverty and underserved communities.
The proposals contained in the Green Book look very familiar by now. Throughout 2022 they did not garner enough votes in Congress to become law. But they are still in play and real estate owners and investors should continue to carefully monitor these proposals as their language will likely continue to change and some may become law at some point. Of course, not knowing the outcome makes investment and estate planning difficult. Industry participants should continue to discuss these new tax proposals with their financial advisors. On a positive note, there may be additional opportunities to invest in affordable housing and community development if Congress passes those aspects of the budget and The Opportunity Zones Transparency, Extension, and Improvement Act.
(1) Information in this article regarding proposed tax law changes are primarily based on the General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals issued by the Department of the Treasury in March 2022.