Update on the Impact on Real Estate of Current Tax Proposals
October 15, 2021
By Joseph Rubin and Kenneth Weissenberg
Earlier this year the Biden Administration introduced the American Families Plan, which contained a number of new tax proposals that would directly impact the net returns on many real estate investments. In particular, a combination of proposals would have greatly increased the taxation of capital gains on the sale of real property for both owners/investors and their estates, with the potential of creating liquidity problems for real estate families.
On September 13, the House Committee on Ways & Means issued a summary of proposed tax reforms in the budget reconciliation bill currently being negotiated by the House, Senate, and White House. Many of the House tax proposals were markedly different than the President’s plan. While all points in the budget reconciliation bill are still being negotiated and the revenue enhancement proposals are far from finalized, there is good news for the real estate industry in that the Administration’s proposals that caused the most concern have largely been excluded from the House draft. Nonetheless, there are many proposals that would clearly impact real estate investing and must be carefully monitored.
The following, and perhaps most impactful, components of the American Families Plan were not included in the House draft:
- Rather than raising the long-term capital gains rate to parity with the ordinary income rate (proposed to be increased to 39.6% for high earning taxpayers), the rate will be increased from the current 20% to 25%.
- IRC Sec. 1031, which allows the deferral of capital gains tax when the proceeds of the sale of real property are reinvested in other properties (a like-kind exchange), was not mentioned in the House summary. The Biden proposal had been to limit the gains deferral to $500,000, but this limitation was not included.
- The House plan did not include the Administration’s proposal to eliminate the allowance to “step up” the tax basis of owned assets upon death, allowing heirs to assume the value at death as their basis. Nor did the House include the proposal to crystalize unrealized gains on assets owned upon the owner’s death. This proposal would have caused estates to incur capital gains tax on properties passed down to heirs, and, for real estate family owned business, may have forced illiquid heirs to sell properties to pay the gains tax.
- The House plan does not change any of the provisions relating to qualified opportunity zones.
The Committee on Ways & Means does propose a number of other changes that would impact real estate owners, fund managers, and investors:
- As mentioned above, the proposal raises the long-term capital gains rate from its current 20% to 25% for higher earning taxpayers. It should be noted that the new rate, as currently drafted, would become effective for transactions after September 13, 2021, the date the House plan was introduced.
- Consistent with the Administration’s proposal, real estate professionals would no longer be exempt from paying net investment income (NII) tax (currently 3.8%) on property operating income and capital gains from real estate ownership activities. This would result in additional tax to real estate owner-operators, developers and fund manager promotes. The NII will continue to be taxed on income from passive real estate investments. [Sec. 138203]
- Under current law, the three-year holding period requirement to achieve capital gains rather than ordinary tax treatment for promote structures does not apply to real estate activities. The proposal changes the rules on the taxation of promotes in several ways: 1) the income subject to reclassification is any gain otherwise taxed at long-term capital gains rates including real estate gains; 2) the holding period to avoid the reclassification has been modified: three years for real estate and five years for any other activities; and 3) the beginning of the three- or five-year holding period would now start once the entity has received and invested substantially all of its capital, meaning that if a fund builds a portfolio of investments over time, the required holding period of three/five years may begin several years into that fund’s operations.
- The Qualified Business Income Deduction created in the 2017 Tax Act allows non-corporate (individual) 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 pass-through entities or REIT structures. The House proposal limits the deduction to $500,000 for higher income taxpayers. As an example, under the current rules, a taxpayer with qualified business income of $5,000,000 was able to deduct 20% of that amount, or $1,000,000. The proposed rule would reduce that deduction to $500,000 resulting in higher taxes for high earning real estate investors, notably REIT shareholders.
- The House proposal also modifies the disallowance of excess business losses for non-corporate taxpayers. Currently, a real estate professional can use up to $500,000 of losses to offset taxable income with any excess losses being treated as a net operating loss (NOL) carryforward to be used in future years. The new rules would change the treatment of the excess loss carryforward from being treated as an NOL to being treated as a business loss in the subsequent year. This substantially limits the losses real estate professionals can use to offset other types of income. As an example, under the current rules if a real estate professional has $2,000,000 in other earnings and $1,000,000 excess business loss, the earnings are reduced by $500,000 to $1,500,000 and the remaining loss of $500,000 is carried to the following year. In Year 2, if the professional has an additional $2,000,000 in earnings and $500,000 in losses, the earnings can be offset by the second-year allowance of $500,000 AND the NOL carryforward of $500,000, reducing taxable income to $1,000,000. While the proposed rules would treat the taxpayer as incurring $500,000 of losses from the prior year plus $500,000 of losses in the current year, or an aggregate business loss of $1,000,000, the proposal would limit the allowable losses to $500,000, resulting in taxable income of $1,500,000.
- One proposed change could impact how real estate owners and investors conduct their estate planning. Currently, owners and investors can use grantor trusts to move ownership interests to their heirs during their lifetimes. 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 sale 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. 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 negotiations over all the provisions of the budget reconciliation package, including revenue initiatives, may go on for weeks, and the final picture of what’s in and what’s on the cutting room floor is far from certain. To date, the real estate industry has avoided some of the most consequential proposals put forth by the Administration earlier this year. However, owners and investors should continue to watch developments in Washington and consult with their tax advisors.