WHITE PAPER: A Tax Wave Is Coming1 Jun 2021
By: James Nelson
With the pandemic seemingly under control, investors are now turning their attention to their next big concern – taxes. With the new administration, there are several proposals which could have a major impact on real estate investments. They include 1) the elimination of the 1031 2) the increase of capital gains 3) the increase in carried interest tax and 4) the loss of the stepped-up basis. The question is to what extent these provisions will change and when, if at all, they will happen. Before I go on, I must give the disclaimer that I am certainly not a tax expert so please verify all of this with your accountant or tax advisor before taking any action.
With the 1031, the Biden administration has proposed to eliminate exchanges over $500,000 as part of its American Families Plans. If passed, this would no doubt be a huge hit to our industry. I can attest that half of our transactions involve a 1031 on the seller or buyer’s side. For NNN sales, I have heard that 70% of the buyers utilize a 1031. I am even working on a transaction now where the seller wants a contingency where the contract will be terminated if the 1031 is eliminated. Clearly, the 1031 drives a great deal of our sales activity. Luckily, I am hearing this might not happen this year.
The opposition has been strong. According to the Real Deal “In mid-March, a coalition of 31 trade associations — including American Farm Bureau Federation, American Hotel & Lodging Association, Mortgage Bankers Association and National Association of Realtors — sent a five-page letter to Treasury Secretary Janet Yellen and members of the Senate Finance and House Ways and Means committees, underscoring the importance of 1031 exchanges to the nation’s economic health. Citing research from Ernst & Young, the letter said that like-kind exchanges support an estimated 568,000 jobs, generating over $55 billion annually, in addition to $27.5 billion in labor income. It also asserted that provision helps prevent properties from being “underutilized and underinvested.” I am hopeful that the Biden Administration will take this all into account and rethink their position.
With respects to the capital gains, it initially looked like the top tax bracket (above $1m) could see an increase from 23.8% to a whopping 43.4%. It now looks like President Biden has revised this “down” to 39.6%. That being said, it could be retroactive back to April of this year. This is a scary proposition for long term owners looking to cash out now or over the last few months with a low basis. According to Fox Business, “Still, the tax increase faces an uncertain future in Congress: Republican lawmakers have balked at the scale of Biden's spending plans and have unified to protect the 2017 tax law from any potential rollbacks. Some moderate Democrats have also raised concerns about Biden's the proposed increases, warning that higher tax rates could derail the nascent economic recovery from the coronavirus pandemic.”
Carried interest could also be subject to a much higher income taxation rate. According to Eisner Amper’s site, “Many real estate investment vehicles are sponsored by a general partner or managing member, depending on the legal form of the entity, that is entitled to a share of the profits associated with the investment based on certain performance hurdles. This share of the profit is often referred to as the sponsor’s carried interest or “promote.” Currently, promotes in real estate partnerships are generally taxed at the long-term capital gains tax rate. The proposal would treat promote interests as ordinary income without regard to the proposed change to the capital gains rate discussed above. As a result, the sponsors would receive less net profits, possibly reducing their incentive to aggregate capital to invest in improving real properties.”
As far as the estate taxes, according to Forbes, “Tucked away in the American Families Plan, is a proposal to change the way capital gains taxes are paid on estates when people pass away. This seemingly small revision to a tax rule called stepped-up basis could cause average Americans to pay more to Uncle Sam than they would under the current tax regime.” This could be a massive hit to those who inherent property worth over $1,000,000 whereupon many would have to sell if they couldn’t pay the estate tax. Fortunately, according to the Forbes article, the Biden administration has not signaled that they want to lower the $11,700,000 individual exemption.
With all these proposals looming, I am expecting to see big rush in sale activity before year end. Owners will hope that these proposals will not be retroactive and instead be staved off until 2022. This would not be the first time this has happened. I remember back to the 4th quarter of 2012, when my previous firm Massey Knakal sold 100 buildings in the month of December alone out of 400 for the year. The reasoning was that the Federal capital gains rate increased from 15% to 23.8% the following year. We could see a similar sell off for the second half of this year, but then we could see a substantially reduction in sales transactions in 2022 as owners hope to wait these proposals out.