Recent blog posts here have talked about how President Biden proposes to boost the federal taxes some small businesses and their owners pay. But Mr. Biden targets another group of entrepreneurs for a tax increase, too: Real estate investors.
Accordingly, in this third blog post about how Mr. Biden’s proposals affect small business, I talk about these parts of the Biden real estate tax proposals.
But let me make a couple of quick comments to provide context.
Biden Real Estate Tax Proposals: The Big Picture
First, a theme appears in Mr. Biden’s proposals. That theme? Investors and entrepreneurs need to pay higher tax rates as their wealth and income grows. In most situations, for example, Mr. Biden proposes to rather substantially bump up the taxes on big investment windfalls and entrepreneurial profits.
A second comment, however: The proposed Biden taxes hit few taxpayers. Really only people with very high incomes. So, like, just the top one percent.
Finally, for those folks? Smart tax planning should often let them better manage the tax increase. At least in many situations. (The trick? Smooth profits and gains so more income gets taxed at low rates and less at the highest rates.)
And now let’s talk about the ways Mr. Biden proposes to raise taxes on real estate investors.
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 our blog post last week about how this same tax increase works for S corporation shareholders, we stepped through the bookkeeping. In a nutshell, some real estate investors currently avoid the Obamacare tax. (Details here.) 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 $3800.
Mr. Biden proposes making this tax increase effective starting in 2022.
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.
This reminder. 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.
But 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 up that rate 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 get 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 tax 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. Accordingly, if you’re reading this? You may be too late to avoid the new tax on really large capital gains.
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 trick, 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.
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…
That first change? It concerns Section 461(l) excess business loss limitations.
The legislative history on this code section? 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, then, 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.
And 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 Section 461(l) 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.
Step-up in Basis Eliminated
A final change some real estate investors face. Mr. Biden wants to eliminate the step-up in basis that currently occurs when a taxpayer dies.
We talked about the way the Section 1014 step-up in basis benefits real estate investors before. (See A Dozen Reasons for Direct Real Estate Investment.) So let me just provide a quick summary here of the way some real estate investing families work this tax planning gambit.
But a trigger warning first: This is a little morbid…
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 this 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 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.
You can see the way the tax savings snowball.
Mr. Biden’s 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? Taxed as regular long-term capital gains. The other $7,000,000? 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.
We discussed Mr. Biden’s proposals for small C corporations including the new higher capital gains tax rate here: Avoiding Biden Tax Increases on Small Corporations
We discussed Mr. Biden’s proposals for levying the Obamacare tax on S corporations here, Biden S Corporation Tax Proposal Caps Savings, but the same logic applies to active real estate investors.
David Wessel did a good article about reconciliation process which the U.S. Congress can use for tax law changes here: What is Reconciliation? If you don’t understand how Mr. Biden can change tax law given the roughly even split in the U.S. Senate, you may want to skim that article.
At the time, I’m writing this, little detailed guidance exists for Section 461(l) excess business loss limitations other than the statute and the 2019 Form 461 instructions. But Tax Advisor magazine published a useful summary in 2019 here.
Finally, the Treasury Green Book, which describes in detail the tax proposals, appears here.