Impact of Biden’s Tax Reform on the Real Estate Industry
Although President Joe Biden took office a mere six months ago, his COVID recovery polices and proposed tax changes are sweeping. When it comes to the real estate industry specifically, there are key tax changes that may impact future planning – as well as various ways to minimize exposure. (It is important to note that these items are merely proposed. They have not yet been passed into law.)
Currently, 1031 exchanges (like-kind exchanges) allow investors to defer capital gains taxes on the sale of real estate by reinvesting the proceeds in other like-kind properties within 180 days of sale. Investors can defer tax liabilities indefinitely by repeatedly engaging in like-kind exchanges and selling properties and rolling proceeds.
Biden’s proposal would limit the deferral of capital gains from 1031 exchanges on real estate transactions to $500,000 for individual filers and $1,000,000 for those married-filing-jointly.
Long-Term Capital Gains and QOZs
Biden has proposed a hike in the tax rate of capital gains for taxpayers with an adjusted gross income exceeding $1 million from a 20% maximum rate (plus 3.8% net investment income tax) to 39.6% (plus 3.8% net investment income tax). A proposed tax plan that nearly doubles the capital gains rate would dramatically impact the real estate industry.
Even if tax rates increased as proposed, there are still opportunities for tax planning. Taxpayers can defer tax on capital gains by reinvesting those gains into a Qualified Opportunity Fund (QOF). The advantages include:
- Deferral of tax on capital gains reinvested into a QOF until 2026
- If the investment is held for at least five years by 2026, then 10% of the previously deferred gain is tax-free (means investment must be made by 12/31/2021)
- If the investment is held for at least 10 years, there is no capital gains tax on the appreciation of the investment including depreciation recapture
In short, QOFs can be a great investment vehicle to hedge against future tax uncertainty. The capital gain deferral component can provide value to any real estate investor through multiple years of tax-free appreciation. It is important to note that deferred gain will retain its character and be taxed at whatever the current tax rates are in 2026.
(Cost segregation studies can be another important tool to consider regardless of a tax rate increase.)
Under current tax law, the cost basis of an inherited asset will generally be adjusted (stepped up or down) to the fair market value as of the date of death; no taxes are due until the asset is sold. This can significantly mitigate capital gains tax exposure upon disposition of an inherited asset.
Under Biden’s proposal, tax on the unrealized gain would be due upon transfer by gift or death. The donor would realize an amount of gain equal to the excess of the asset’s fair market value on the date of the gift over the donor’s basis in the asset. The decedent would realize an amount of gain equal to the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in the asset. This proposal implies that assets passed down from the prior owner at death triggers a recognition event, and that the gain would be taxable income to the decedent on the Federal gift or estate tax return or on a separate capital gains return.
The proposal would allow a $1 million per-person exclusion from recognition of unrealized gains on assets transferred by gift or held at death ($2 million per married couple).
The carried interest changes in the Tax Cuts and Jobs Act (TCJA) allow hedge fund and real estate fund managers to pay preferential tax rates on their capital gains if they held their carried interest for greater than three years. Biden’s proposal would potentially eliminate capital gain treatment on carried interests and instead they would be subject to ordinary income rates and self-employment taxes. It is unclear if this proposal would eliminate the current exclusion from the three-year holding period rule that apply to certain real estate funds.
Biden’s tax proposals are continuously evolving. KSM continues to monitor the developments and will provide updates as new information is available. Please reach out to your KSM advisor to discuss the potential impacts on your real estate business or complete this form.
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