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Biden Real Estate Tax Proposals

(posted: August 18th, 2021)

1. High Income Real Estate Investors Hit with Obamacare Tax

A first tax bump? Mr. Biden wants real estate investors with high incomes to pay either the 3.8 percent net investment income tax or the 3.8 percent self-employment contributions act tax. In a nutshell, some real estate investors currently avoid the Obamacare tax. But going forward, Mr. Biden wants those real estate investors with large adjusted gross incomes to pay the 3.8 percent tax on the chunk of their business income in excess of $400,000.

A simple example: A real estate investor earns $500,000 from her or his real estate investments. This investor pays a 3.8 percent tax on the last $100,000 of income. That amount equals $3,800.

Mr. Biden proposes making this tax increase effective starting in 2022.

2. No Preferential Tax Rate for Capital Gains Taxes for High Income Investors

Another tax bump Mr. Biden proposes? He proposes that investors with seven figure taxable incomes pay ordinary income tax rates on at least some of their capital gains. Middle-class taxpayers usually pay a zero-percent long-term capital gains tax rate. Upper-class taxpayers usually pay a 15 percent long-term capital gains tax rate. And sometimes, if the taxpayer's income gets high enough, a 20 percent long-term capital gains rate.

Mr. Biden proposes that all these taxpayers continue to pay the same zero, 15 or 20 percent long-term capital gains rate. The hitch? Once a taxpayer's taxable income crosses the $1,000,000 threshold, he wants the taxpayer to pay the highest marginal tax rate. For 2021, that tax rate equals 37 percent. He proposes bumping that rate up to 39.6 percent after 2021.

An example using big but simple numbers: Say a taxpayer earns $500,000 in W-2 wages and then receives a $1,000,000 long-term capital gain from the sale of a real estate investment. The first $500,000 of the real estate investment gains get taxed as long-term capital gains. Probably, the rate equals 20 percent. The last $500,000 of the real estate investment gains gets taxed as, essentially, ordinary income. Mr. Biden wants that rate set at 39.6 percent.

Accordingly, this taxpayer doesn't pay a 39.6 percent long-term capital gains on all their capital gain. The taxpayer pays a blended long-term capital gains tax rate. Roughly 30 percent with the example numbers given.

Note: Mr. Biden proposes making this change in tax laws effective retroactively to sometime in 2021. You may be too late to avoid the new tax on really large capital gains.

3. Section 1031 Like-Kind Exchanges Limited

Under current tax law, real estate investors may be able to exchange one property for another and thereby delay paying taxes on the income or gain.

For example: If an investor buys a property for $100,000 and it appreciates in value to $1,000,000, she or he can probably exchange, or swap, that $1,000,000 property for another $1,000,000 property and avoid paying taxes.

Mr. Biden proposes dialing down this tax-deferral regulation, however. He suggests tax law limit taxpayers to deferring no more than $500,000 annually using the Section 1031 like-kind exchange rules.

The bookkeeping and tax return arithmetic for like-kind exchanges gets tricky. But we guess that real estate investors who historically used a like-kind exchange to delay paying taxes may want to reconsider that tactic from this point forward.

Mr. Biden proposes making this tax increase effective starting in 2022.

4. Excess Business Losses Limited (Again)

Two other general tax law proposals from Mr. Biden may impact real estate investors, too. Though note that these changes affect only the highest income and highest net worth taxpayers and the first of these changes isn't really new from Mr. Biden. More of a tweak to an existing law...

The first change concerns Section 461(l) excess business loss limitations.

The legislative history on this code section is complicated because of Covid-19. But basically up through 2020, a taxpayer could engineer situations where he or she used large business losses, including real estate losses, to shelter unlimited amounts of income, including W-2 income and portfolio income.

For example: Suppose a married couple includes a highly-paid executive earning $2,000,000 and the other spouse qualifies as a real estate professional by managing the family's real estate portfolio. Further suppose through depreciation deductions, the real estate professional spouse loses $2,000,000 a year. In the past, this couple reported zero taxable income and paid no taxes. Starting in 2021, however, the law limits the business losses that can be deducted to the sum of the business income a taxpayer recognizes plus in 2021 another $524,000 if married or another $262,000 if single. (The IRS adjusts these amounts annually for inflation.)

In the example provided here, the couple probably realizes no business income which can be sheltered. The couple can therefore probably shelter only $524,000 or roughly a quarter of the W-2 income.

How this connects to Mr. Biden's tax proposals? While Section 461(l) became effective (for the second time) starting in 2021, the law currently expires after 2026. Mr. Biden however proposes making the excess business loss limitation permanent. Which means that the trick some high income taxpayers have used to rather permanently shelter income using real estate may go away permanently.

5. Step-up in Basis Eliminated

A final change some real estate investors face is Mr. Biden wants to eliminate the step-up in basis that currently occurs when a taxpayer dies.

A real estate investor can bequest a property to her or his heirs. And when that happens under current law, the basis of the property gets reset, or "stepped up," to the fair market value at or around the time the taxpayer died. The new owner can then sell the property without paying tax or restart the depreciation using the stepped-up basis.

For example: Say your grandfather bought an apartment house for $100,000 decades ago and even enjoyed years of tax-free rental income from depreciation deductions. Then, say he died with the apartment part of his estate and he bequeathed the apartment house, now worth $1,000,000, to your mom. Neither the estate nor your mom owes taxes in this situation. In fact, your mom can sell the apartment building for $1,000,000 and pay zero income taxes, or she can continue to hold the property and restart depreciation deductions based on the stepped up $1,000,000 value. Further, your family can continue this arrangement in future generations. If your mom holds the property in her estate and then you inherit the apartment house when it's worth $10,000,000, under the current law, you can sell the property for $10,000,000 without paying income taxes, or you can continue to hold the property and also restart the depreciation deductions based on that $10,000,000 valuation.

Mr. Biden responds with two proposed tax law changes. First he eliminates the step-up in basis. Second, he taxes the economic gain the decedent would have realized if she or he had sold the property on the date she or he died.

One other wrinkle to the proposal. Mr. Biden proposes excluding from this taxation $250,000 of gain related to a principal residence as well as another $1,000,000 for other assets. Further, gains on personal property (other than collectibles) get ignored and a surviving spouse doubles the $250,000 and $1,000,000 exclusion amounts.

An example shows how this might work. You and your siblings inherit a fully depreciated apartment house worth $10,000,000 from your parents. Let's say this is the only asset in the estate. To keep the example easy, let's also say your parents' cost basis of the apartment equals zero. In this case, the imputed gain when your last surviving parent passes away equals $10,000,000 and your surviving parent's estate owes taxes on $8,000,000 after the two $1,000,000 exclusions. The first $1,000,000 of this gain is taxed as regular long-term capital gains. The other $7,000,000 is taxed as ordinary income.

To deal with the liquidity issues inherent in taxing illiquid assets, Mr. Biden helpfully proposes letting the estate pay the tax over 15 years.

This change Mr. Biden apparently proposes making effective starting in 2022.

Closing Comments on Biden Real Estate Tax Proposals

Whether Mr. Biden's tax proposals become law? Who knows. But clearly taxpayers emphasizing real estate investment want to carefully follow the discussion.

Further, if even some of the Biden real estate tax proposals do become law, many real estate investors will want to reassess their strategy and their tactics.

In Conclusion

These proposed changes, if enacted, could shut down real estate sales and acquisitions, and therefore, a major segment of the economy while these real estate tax proposals are in effect.

Please Contact Us if you need additional insight or advice.

1 Comment

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thanks for the info.very helpful hopefully biden gets impeached and all of his idiotic minions working for him will go away (and, thanks for the wine tip)

Posted by Dave

(Aug 20th, 2021  5:02 PM)

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