Many of President Biden’s campaign proposals may never materialize in the face of changed circumstances or political and legislative realities. However, some significant tax laws seem likely to pass—probably not in 2021 but very possibly in 2022.
Historically, changes to our tax codes are not grandfathered back to preceding years. Therefore, 2021 may be an opportune time for small business and commercial real estate property owners to reevaluate their current CRE situations to prepare for coming shifts.
Among the President’s desired changes:
1031 Tax-Free Exchanges
Biden’s plan proposes removing the right to defer taxes on property gains over $500,000. Currently, investors can use 1031 exchanges to buy and sell tax-deferred real estate throughout life. If the investor holds the property until death, they can pass it on to heirs tax free.
According to a 2020 survey from the National Association of Realtors, approximately 12 percent of real estate sales between 2016 and 2019 were part of a 1031 exchange. The congressional Joint Committee on Taxation recently estimated that 1031 exchanges may save investors $41.4 billion in taxes from 2020 to 2024.
Some financial experts believe the tax hike may put a strain on smaller investors. As described, Biden’s plan targets the wealthy, but most 1031 investors likely are not real estate tycoons but small business owners and entrepreneurs. In fact, NAR’s survey showed 84 percent of 1031 exchanges were transacted by smaller investors—those in sole proprietorships (47 percent) or S corporations (37 percent).
Small businesses looking to exchange property may face some tough decisions.
For example, let’s say a tractor manufacturer owns a $1.2 million building it had originally purchased for $500,000. Under current law, the owners can exchange the property for a “like-kind” office building and defer taxes by adding the $700,000 profit into a new building they’ve bought.
The proposed new law would charge capital gains taxes on the company’s profit above the $500,000 exemption. That could make it difficult for those looking to exchange for a lower-maintenance property as they move into retirement.
Furthermore, the tax deferral allowed by Section 1031 like-kind exchanges enables real estate investors to shift resources to more productive properties or to change geographic locations. Because of accumulated depreciation allowances on real property, the added taxes on a sale of the real estate create a “lock-in” effect.
The proposed changes may also trickle down to small businesses renting property. Sixty-eight percent of those surveyed by the NAR expect rent increases if 1031 exchange repeals occur. Landlords may try to recoup losses or extra taxes by charging more rent.
Most industry professionals believe elimination or significant change of Section 1031 rules would result in a major reduction in real estate transactions, ultimately harming economic growth.
Capital Gains Treatment
Currently, the top tax rate on capital gains, which applies to higher-income earners, is 20 percent. President Biden’s proposal would increase the capital gains rate for those with incomes of over $1 million per year to the top rate on ordinary income, which under his plan would be 39.6 percent.
If you include the current 3.8 percent net investment income tax that is imposed on those earning more than $200,000 annually ($250,000 for married couples), then the increase would be from 23.8 percent to 43.4 percent, an almost doubling of the capital gains tax rate for high-income investors.
Small business property owners looking to cash in on increases in commercial real estate prices could see significant changes. Proposed increases in federal as well as some state capital gains tax rates could significantly change profit margins and taxes for sellers.
Effects on Carried Interest for Real Estate Promoters
A carried interest (also known as a “promote”) is a profits interest in a venture that exceeds the capital contribution made by the recipient of the interest. In the real estate context, a common practice is for investors (limited partners) that provide the funding to give such an interest to the developer (the general partner) as a means of aligning their mutual interests in the ultimate success of the project.
Carried interest has traditionally been taxed as capital gains. Biden’s proposal would tax it as ordinary income, effectively raising rates on many real estate entrepreneurs from 20 percent to 39.6 percent.
Increased Taxes on Pass-Through Entities
Taxation of carried interest was limited by the Tax Cuts and Jobs Act, passed in 2017, to those assets held for more than three years. This eliminated the potential to mischaracterize income that was more in the nature of ordinary income as capital gains. And the 20 percent deduction for pass-through entities was necessitated by the reduction of the corporate tax rate from 35 percent to 21 percent. Without it, pass-throughs would have been severely disadvantaged compared to corporations, with investment flowing toward the latter. Real estate is predominantly held in pass-through form, with 1.9 million real estate partnerships in the United States
Biden would repeal the current 20 percent deduction for qualified business income earned by partnerships, limited liability companies, sole proprietorships and other so-called pass-through entities as it applies to taxpayers earning more than $400,000 per year (Section 199A). Income earned by these entities would normally be taxed at the ordinary income rate (currently 37 percent). The 20 percent deduction effectively makes income earned through pass-throughs taxable at a 29.6 percent rate.
Historically, a differential between tax rates on capital gains and those on ordinary income has been key for commercial real estate investment, providing incentive to take on the inherent risk in a long-term, capital-intensive investment like real estate.
Undoubtedly, there will need to be much work and compromise in the coming months and possibly years to achieve significant changes to our tax code as it relates to the commercial real estate industry—critical, given its importance to the national and global economy.
Daniel Levison is CEO of CRE Holdings comprising Atlanta Investment Properties, Commercial Property Consultants and Sharedspace, and co-founder of CommissionTrac.