President Biden’s policy initiative provides for several tax proposals that would have a significant impact on the real estate industry. The following is a summary of the changes that would have the most impact on current and future real estate investments.
Carried Interests Taxed at Ordinary Rates
Carried interests are common in real estate transactions and are sometimes referred to as “sweat equity”. Carried interests involve development, financing and construction risks taken on by the general partner. Under current law, these returns are frequently taxed at capital gains tax rates. President Biden’s budget proposes to tax carried interests as ordinary income which could result in a massive tax increase for those who utilize partnerships to own, operate and develop real estate. A change in the taxation of carried interests could severely dampen the real estate market and increase the cost to construct real estate.
Capital Gains Tax Rate Increase
Another proposal that will significantly change the way real estate transactions are structured is an increase to the capital gains taxes. The Biden tax plan proposes to tax long-term capital gains for those taxpayers with adjusted gross income (AGI) greater than $1 million, at a top marginal rate of 43.4% when factoring in the increase to the top rate from 37% to 39.6%, as well as the 3.8% Net Investment Income Tax (NIIT). Currently these gains are taxed at 20% prior to the NIIT, this increase would almost double the tax due as compared to current rates. Under the Biden plan, the NIIT would be applied to active pass-through business income for those taxpayers earning over $400,000.
Elimination of 20% Passthrough Deduction
The Biden plan calls for a phasing out of the Qualified Business Income (QBI) deduction, commonly referred to as the 20% passthrough deduction. The QBI deduction was implemented under the Tax Cuts and Jobs Act (TCJA) and is a potential 20% reduction in partnership income passed through to investors. The proposal calls for an elimination of the QBI deduction for those taxpayers with AGI greater than $400,000.
Elimination of Bonus Depreciation
Another item under consideration is a proposal to eliminate bonus depreciation for certain commercial property. Currently, a commercial property owner who places certain property into service during the year can deduct 100% of the cost through bonus depreciation. Under the Biden proposal, the immediate deduction would be eliminated, and the property owner would need to claim the recovery over a 39-year period.
Elimination of Basis Adjustment Upon Death
President Biden’s plan also calls for an elimination of the step-up in basis upon death. Currently, taxpayers are allowed to pass property on to their heirs at fair market value at time of death instead of the original purchase price. As the law is currently written, taxpayers receive a basis step-up at death of up to $23M for couples who are married filing jointly. The elimination of this basis step-up upon death could mean that taxpayers are paying capital gains taxes on inherited property. In addition to this, the plan also calls for an increase in the estate tax from its current 40% rate to an increased rate of 45% as well as lowering the exemption per person to $3.5M.
Limitation on Section 1031 Like-Kind Exchanges
Section 1031 allows a deferral of capital gains by selling one property and acquiring similar property within a specified period. The taxpayer does not pay taxes until the replacement property is ultimately sold. Biden’s plan proposes to limit Section 1031 Like-Kind Exchanges to $500,000 in deferred capital gains. This new law would tax capital gains over $500,000 in a Like-Kind Exchange. The increased taxes could severely limit deals going forward as well as cause rents to increase as the landlords would need to recoup the lost money paid in additional taxes.
Next Steps
It would be prudent to review your portfolio and consult with your tax advisor about what, if any, actions you should take. The items above are just some of the proposals that are in the Biden plan, and negotiations will clearly impact the law that is ultimately written.
If you would like to discuss the potential impact of the Biden proposals, please contact a member of your DGC client service team or Keith LeBlanc, CPA. Keith is a Principal in the Real Estate practice and can be reached at 781-937-5149 / kleblanc@dgccpa.com.
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