September 2021 issue
Potential Tax Changes Will Affect Your Investment Real Estate and More
By Kent A. Fitzpatrick, AIFA, GFS
As we wind down the last weeks of summer we start to think about the transitions that a new season brings. There are winds of change picking up with the various plans, proposals and bills on Capitol Hill that will bring forth sweeping modifications to federal tax laws. Before we discuss how this relates to your income taxes, investment real estate, or other investments, let’s review what is on the table.
Earlier this year, the Biden Administration outlined extensive changes to the Internal Revenue Code with the introduction of three plans and the release of the Fiscal Year 2022 Revenue Proposals (sometimes called the Green Book). The core of these plans was to address Covid, infrastructure, education, and family medical leave. The first was on March 11, 2021 with The American Rescue Plan (aka COVID-19 Stimulus Package). This was enacted with the passage of a $1.9T bill to provide vaccine aid and stimulus checks. The second was The American Jobs Plan, which was proposed on March 31, 2021 with an initial estimated cost of $2.65T to create jobs and rebuild American infrastructure. The third was The American Families Plan that was proposed on April 28, 2021. This has an estimated cost of $1.8T to focus on education, funding the IRS, and family medical leave.
Although the Senate passed a $1T bipartisan infrastructure bill on August 10, 2021, the agreement did not include a number of President Biden’s priorities in his original plan or campaign promises. The bill will likely go to vote in late September to end a standoff between party legislative agendas. To sidestep Republicans, Democrats are hoping to pass a separate $6 trillion reconciliation package that could advance key elements of President Biden’s infrastructure plan along with additional reforms. Stay tuned to see how this plays out.
So how does all this spending get paid for? By American businesses and taxpayers, of course. Here is a quick summary of some of the proposed changes:
- Increase the corporate income tax rate from 21% to 28%.
- New limitation on interest deductions.
- Impose a minimum 15% corporate income tax on the “book” earnings of large corporations.
- Increase top individual rate from 37% to 39.6%, as well as lowering the top income threshold to be included this top bracket.
- Increase capital gain rates: Tax capital gains as ordinary income for high income earners, believed to be retroactive to 4/28/21. Combined with the Net Investment Income Tax (NIIT) it would raise the capital gains tax rate to 43.4% for the sale of real estate or other appreciated investment assets for top taxpayers.
- Increase federal employment taxes and NIIT.
- Tax Carried (profits) Interests as ordinary income. This would apply to investment partnerships, such as private equity partners.
- Subject gifts and death transfers to capital gains taxes — eliminating the step up in basis. (Recognize gain on appreciated property transferred by gift or at death).
- NIIT base would expand to include income and gain from trades or businesses not otherwise subject to employment taxes.
- Significantly limit “like-kind” exchanges under Section 1031 — Limit IRC §1031 to $500,000 in gain. Each taxpayer would be allowed to defer up to $500,000 of gain each year ($1 million for married taxpayers filing jointly).
For our readers the three primary potential tax changes with the most impact to you, your investments and income are: Limitation on 1031 exchanges, the nearly doubling of the capital gains tax rate, and the elimination of stepped up basis. Section 1031 of the Internal Revenue Code, which has been in place for 100 years, provides an effective strategy for real estate investors to defer the capital gains tax that may arise from the sale of your business/investment real property. By exchanging the property for like-kind real estate, property owners may defer their tax and use all the sale proceeds for the purchase of replacement property, which includes the use of a passive solution called a Delaware Statutory Trust (DST). This can be a tremendous estate and income planning tool depending on the investor’s circumstances.
There is an expression, “owners maintain, buyers renovate.” As an investment property owner, the new tax treatment means you are going to be disincentivized to sell due to high taxes — which is not stimulative to the economy. Recent economic impact studies from EY concluded that like-kind exchanges are a powerful stimulant of transactional activity that will create 568,000 jobs, including $27.5 billion of labor income and a total of $55.3 billion of value added to the U.S. economy. Limiting 1031 exchanges could have a profound impact on not only investment real estate, but the health of the economy as a whole.
Prior to the Biden Administration introducing the proposed increase to capital gains rates, the Tax Cuts and Jobs Act (TCJA) of 2017 introduced a new law called the Investment in Opportunity Act, also known as the Opportunity Zone Program. This allows an investor with any capital gain, long or short, related to real estate or otherwise, to reinvest that gain within 180 days (exceptions apply to gains from passthrough entities such as a partnership or LLC partnership) to defer paying any Federal tax until the end of 2026. This reduces the tax due by 10% (provided the Qualified Opportunity Fund (QOF) investment met the 5-year hold and was set up by 12/31/2021 – another approaching deadline to keep in mind), and if the investment in the QOF is held for 10 years, avoids any further tax in the appreciation of the investment. In essence, you can defer and reduce the current tax due and eliminate future tax on any new appreciation. There are also some profound estate planning benefits for transferring these types of funds because death is not a triggering event, and the beneficiary can retain these tax advantages.
If your “Plan B” was to leave appreciated assets to your kids so they would get the step up in basis at death (taxing any appreciation in assets at the time of death or subsequent sale), that may be off the table as well. This, compounded with a likely increase in the maximum estate tax rate from 40% to 45% as well as reducing the current estate tax exemption of $11.7M per person to potentially as low as $3.5M, will have additional significant consequences. If any of the proposed changes are retroactive to April 28, 2021, as previously stated, it makes it very difficult to do any planning with certainty. If these changes pass and come with a January 1, 2022 effective date, there are planning solutions you may want to take advantage of before year end. Gifting, to take title of assets out of your name and transfer them to other persons or entities (such as a trust or a non-profit) has never had a greater opportunity to use up the potential $8M difference in the exemption that may be going away. Also, in a historically low interest rate environment, using a Charitable Lead Trust (CLT) where a charity receives annual payments and anything remaining can go to your beneficiaries, a lower valuation of the remainder interest reduces the taxable portion of a gift to your noncharitable beneficiaries. Readers should be reminded to consult with their tax and estate advisor before doing any gifting as well as be aware of the impact of your home state gift and estate tax exemptions.
As you can see, change is in the wind. As investors, know and understand what is in these tax proposals and how you can plan accordingly. Also, you should let your voice be heard by speaking to your member of Congress today: www.1031buildsamerica.org.
Let us know how we can help.
Kent is the Managing Director at Asset Strategy and an Accredited Investment Fiduciary Analyst.
If you are not currently a subscriber. Click the link below to check out our latest trial offer.