President Biden’s tax agenda includes several changes that may affect real estate investors. One of the more high-impact changes is the potential elimination of the 1031 exchange which many real estate investors take advantage of every year. Real estate tax law changes are expected to include:
- Eliminating or modification of the 1031 exchange
- Possible increasing the long-term capital gains tax
- Eliminating or changing the estate step-up in basis
There may also be changes to the corporate tax rate and the Qualified Business Income Deduction. In this article, we’ll explore how these changes may impact investors.
Democrats in Control
With the January 5 Georgia Senate races going to the Democrats, they now effectively control the Senate since the Vice President (also a Democrat) can break any tie. The Democrats also hold a majority in the House of Representatives, giving them full control of Congress. This majority control means that President Biden has a better chance of pushing through new legislation.
1031 Exchange Overview
A 1031 exchange is only applicable for real estate, not stocks. It works like this: an investor owns a piece of real estate that goes up in value. There’s a tax rule that allows the investor to sell the first property and buy another like-kind property.
The investor can defer all gains on the first property, moving them over to the new property. The investor can then continue earning income from the new property while taking advantage of tax deferral on the first property.
If the investor passes away, their asset is stepped up in basis for their beneficiaries. If those beneficiaries decide to sell the property at the stepped-up basis price, they won't have to pay any capital gains taxes.
Impact on Real Estate Investors
There are three main components of Biden’s tax plan to unpack that may affect investors:
Elimination Of 1031 Exchange. If the new tax proposal eliminates the 1031 exchange, investors may lose the ability to fully defer taxes at the time of sale. It is unclear at this junction if a full or partial deferral is under consideration.
Increase In Long-Term Capital Gains Tax. Additionally, there is a proposal to increase long-term capital gains tax rates. Those earning over $1 million may pay 39.6% instead of 20% top rate in capital gains taxes. At that rate, capital gains are taxed at ordinary income tax rates. This will apply to qualified dividends as well. Adding in the 3.8% net investment income surtax can bring the total rate to 43.4%
Elimination Of Step-Up In Basis. Also up for review is to eliminate the step-up in basis at death tax benefit. The step-up in basis allows an investor to pass property to their heirs at the fair market value (at the time of death) rather than at the original purchase price.
As an example of the step-up in basis, if the original purchase price of a property was $500,000 and now it is worth $800,000, the basis to heirs will be $800,000. The heirs will not owe any taxes if the property is sold for that price. The elimination of the step-up means the heirs may owe capital gains taxes on $300,000.
Broader Impact of Eliminating the 1031 Exchange
In addition to the 1031 exchange's eliminations impact on individual investors, there's a trickle-down effect that comes into play. A 2015 study by the National Association of Realtors found that 63% of realtors participated in a like-kind exchange (i.e., 1031 exchange).
That’s a significant amount of business just from 1031 exchanges, considering all of the businesses that participate in 1031 exchange transactions:
- Title companies
Additionally, investors purchasing new property often need to make improvements. Those improvements bring in contractors and the purchase of materials from the local economy.
The 1031 Like-Kind Exchange Coalition also did a 2015 study that showed the impact on the overall economy of repealing like-kind exchanges. The following highlights the results of their findings:
- A fall in GDP of $8.1 billion per year
- A long-run fall in investment of $7 billion
- A long-run fall in labor of $1.4 billion
1031 exchanges provide great tax benefits to real estate investors. Those earning over $1 million may be hit especially hard by the new tax law changes. Not only do they lose the ability to make like-kind exchanges, but they'll also have the potential to be taxed at 39.6% on capital gains. Many heirs may be affected as well by the loss of the step-up in basis associated with the death estate inheritance rule.
However, it isn’t all negative. Real estate and estate transactions will still occur. New taxes collected on those transactions will likely go toward the administration’s infrastructure and healthcare spending initiatives. The closing real estate tax loopholes part of the administration’s tax plan is expected to generate $70 billion in revenue, and eliminating the stepped-up basis is expected to generate another $440 billion. This income may be used to offset the latest, broader COVID-19 stimulus packages.
Business-Related Tax Law Changes
The corporate tax rate may change from 21% to 28%. There may also be a 15% minimum book tax on corporations. The book tax applies to firms with $100 million or more in net income that pay little to no federal income tax. It is called a book tax because it’s based on financial “book” income. It is aimed at firms attempting to avoid paying taxes.
Additionally, the qualified business income deduction (Section 199A) may be phased. This affects tax filers with taxable income of at least $400,000.
Qualified Business Income Deduction (QBID)
The QBID is a complex deduction. It allows tax filers who are not corporations to take a 20% qualified business income deduction. This includes pass-through income entities, which are often used in real estate. The deduction helps to set equality with the 20% corporate tax rate.
This tax proposal may keep the QBID but with some changes. For those earning at least $400,000, the phaseout of the QBID may change. REIT dividends may undergo a number of provisions. The same provisions may apply to safe-harbor rules for rental income/activities from related parties.
When Should We Expect These Tax Reforms?
The new administration will have a full plate coming into office. This may tie up Congress for a while. Including the following high-priority tasks to work through:
- Cabinet nominees
- Vaccine distribution
- Economic stimulus plan
- Environmental policy updates
- Potential impeachment trial for Trump
Looking back at the Trump administration, the implementation of tax reform didn't occur until 2018, a full year after the President had been in office. Some smaller parts of Trump's tax plan were retroactive for 2017. We may see something similar with Biden's tax plan implementation.
1031 Exchange Guidebook
The 1031 Investor's Guidebook