Biden Tax Proposal: Implications For CRE Investors
President Biden's proposed changes to tax law contain significant implications for commercial real estate investors. We've identified three areas where the plan is most likely to affect commercial real estate investors, and offer some predictions of how the market may respond to those changes, which could come as early as 2022.
1. CAPITAL GAINS TAXATION TO INCREASE.
Currently, long-term capital gains realized upon the sale of real estate, stocks or bonds are taxed at a special rate of no more than 20 percent. The Biden Administration proposes taxing capital gains as ordinary income for taxpayers whose annual incomes exceed $1 million (or $500,000 for those married and filing separately).
It is important to note that as ordinary income, gains from a property sale will boost a taxpayer's annual income for that tax year, potentially bumping them up to a higher tax bracket. Ordinary income is currently taxed at incremental rates of up to 37 percent, and the proposal would increase the rate to 39.6 percent for the highest bracket. As a result, for many property owners the tax rate on capital gains would nearly double, from 20% to 39.6%.
2. LIMITS PROPOSED FOR 1031 EXCHANGES.
For the last century, taxpayers have been able to defer gains on the sale of real estate used in a business or held for investment by reinvesting the proceeds to purchase a replacement property (or multiple properties). Section 1031 of the IRS code regulates these like-kind exchanges, which shifts the tax basis of the sold property into the tax basis of the purchased real estate. Instead of paying capital gains tax at the time of sale, in theory, the tax is to be paid when the replacement property is sold.
Biden's proposal stops short of doing away with the 1031 exchange, instead aiming to limit the gains a taxpayer can defer in a single year. The proposal caps that aggregate amount at $500,000 for an individual or $1 million for those married and filing jointly.
3. REPEAL OF THE STEPPED-UP BASIS FOR INHERITED REAL ESTATE.
Presently, property owners can avoid tax consequences to heirs when their property passes from generation to generation. That's because the basis or dollar amount deemed to be invested in the real estate is "stepped up" to market value when one owner dies and another takes over. Without this protection, any increase in the property's value that occurred over the deceased's period of ownership would come to the new owner as a capital gain.
The Biden plan would remove this protection for gains beyond a $1 million exclusion, or $2 million per married couple passing on their real estate. In practice, that means the recipient of a property that had increased in value by $1.5 million during the deceased's ownership would recognize a $1.5 million capital gain; after the $1 million exclusion, they would be taxed on the remaining gain of $500,000 at the time of the transfer. The current market value would then become the new owner's basis.
POSSIBLE IMPLICATIONS FOR CRE INVESTORS
If enacted as law, the President's tax proposal would alter the climate in commercial real estate on several fronts. The immediate effect, which is already occurring, is increased transaction volume as property owners attempt to conclude any property sales before the end of the year. That's probably the earliest that new provisions could affect taxpayer liability.
Don't expect a mass exodus from real estate to alternative investments. Capital gains treatment would be the same for stocks and bonds, so property markets don't lose a comparative advantage under the new plan. The changes would decrease investors' overall returns, however.
Market inventory of properties available for acquisition could decrease as owners lengthen their holding periods rather than sell and realize capital gains. Most 1031 exchange users are non-institutional, private investors and collectively make up 10 percent to 20 percent of the market. Changes to like-kind exchange rules could reduce liquidity for owners unwilling to incur taxable gains, reducing overall transaction volume.
Fewer 1031 participants would mean not only a smaller pool of buyers in the market, but also less upward pressure on pricing. That's because exchange buyers have limited time windows to buy replacement properties, which has made them highly motivated buyers that drive up prices. Removing that influence could lead to lower pricing in 2022 and beyond.
And finally, repealing the stepped-up basis would require many property owners to rethink generational investment plans, since properties could no longer be passed down with a reset basis to avoid taxes on capital gains.
To learn more about these issues and discuss your investment strategy, contact Realty Capital Analytics for a complementary meeting.