Earlier this year, President Biden announced The American Families Plan – a $1.8 trillion proposal focused on investing in increased childcare, healthcare, and education initiatives while extending many of the middle-class focused tax credits that were signed into law earlier this year as part of the American Rescue Plan. The White House has released a fact sheet on the plan.
To fund the plan, Biden has proposed the following:
- Restore the top income tax rate for taxpayers making more than $400,000 per year to 39.6%
- Boost the highest capital gains tax rate for taxpayers making more than $1 million per year to 39.6%
- Apply the 3.8% Medicare tax uniformly to all taxpayers making more than $400,000 annually
- Limit 1031 exchanges for real estate gains at $500,000
- Eliminate the step-up in basis for gains more than $1 million, or $2.5 million for couples
- Tax carried interest income allocations as ordinary income versus capital gains
- Extend permanently excess business loss limitation under section 461(l)
- Expand IRS enforcement against wealthy taxpayers
At this stage, the American Families Plan is just a plan, and it remains to be seen whether the proposals in the plan will enacted into law. Yet, it is worth looking at how some of these initiatives may impact real estate investors and developers.
Tax Rate Increases
The Biden plan would raise the top federal income tax rate on capital gains and dividends from 20% to 39.6% for households with income greater than $1 million per year. When factoring in net investment income taxes (i.e., Medicare tax) of 3.8%, the President’s proposal would increase the maximum rate paid on capital gains to a total of 43.4%.
There is currently still uncertainty as to what will be includible in the $1 million threshold (gross income, adjusted gross income, taxable income, etc.). The implication for real estate is that it will likely discourage and/or delay owners from selling. Also, property owners might opt refinance their next acquisitions instead, which will decrease the supply and drive-up prices.
In addition, the American Families Plan proposes an increase to the top marginal ordinary income rate for individuals from 37% to 39.6%. This would reverse the decrease in the tax rate under the 2017 Tax Cuts & Jobs Act.
The American Families Plan proposes to abolish tax-deferred Section 1031 like-kind exchange treatment for capital gains greater than $500,000. Previously, the 2017 Tax Cuts and Jobs Act had eliminated tax-deferred Section 1031 like-kind exchange treatment for all property other than real property.
This move coupled with the proposed increase in capital gains tax rates could cause a domino effect through the real estate industry. An EY report identified several challenges for repealing like-kind exchanges, including a higher tax burden, longer holding periods, and increased debt financing. These effects are still expected to occur if the proposal to limit like-kind exchanges becomes law.
Eliminating Step-Up in Basis
Presently, unrealized gains at death can be passed on to heirs, thus deferring taxes until the property is later sold. The step-up in basis is secured and readjusted at the time of death.
The American Families Plan proposes eliminating the step-up in basis and recognizing the date of death as a taxable event. This change would treat assets like a home or business as a sale rather than inheritance and would be taxed proportionately at the time of death.
A press release issued by the Department of Agriculture indicates that there would be protections “so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”
This would have a dramatic impact on multi-generation wealth. According to the Joint Committee on Taxation, this tactic saves U.S. taxpayers about $41 billion per year.
Removal of Capital Gain Treatment for Carried Interest
The use of carried interest by hedge fund and private equity managers often affords them the ability to pay taxes on their share of income at capital gains rates. The American Families Plan proposes to remove this eligibility of capital gains treatment on carried interest which means that carried interest income allocations would be taxed as ordinary income rather than capital gains. How this will affect real estate is uncertain especially if the proposal extends beyond “hedge fund” partners to partners of real estate partnerships.
Excess Business Loss Limitation
The American Families Plan would make permanent the current rule disallowing excess business losses of non-corporate taxpayers. This rule (i.e., section 461(l) was enacted as part of the 2017 Tax Cuts and Jobs Act to disallow certain business losses (including losses allocated from real estate and other partnerships) more than $250,000 ($500,000 if filing a joint return). The provision is currently set to expire at the end of 2025, but, the American Families Plan would permanently extend the section 461(l) loss limitation provisions, thus permanently restricting the deductibility of excess active pass-through business losses.
The most important to thing to note is that the tax proposals in the American Families Plan are just “proposals” and can change quite a bit before for they ultimately become law. Still, they provide an insight into what the Administration is considering in terms of tax reform and how these items will change the real industry.
Research indicates that when tax policy is changed, real estate investor behavior changes too. For example, if long-term capital gains rates are eliminated, other strategies could include installment sales, seller financing, increase rents or fewer capital projects.
RINA will continue to monitor developments and will provide further updates as more details are released. In the meantime, RINA would be pleased to assist you in your analysis of these proposals.