As Washington lawmakers tangle over the details of President Biden’s economic agenda, real estate investors and their tax advisors are trying to figure out what it all means — often in the heat of the deal.
“Life is going on and transactions are being done,” said Michael Greenwald, a partner at the accounting firm Friedman. “It makes it very difficult for people to plan.”
Tax reform is the number-one issue right now at many of the big accounting firms. But formulating a tax strategy when the winds out of Washington seem to shift multiple times a day is like trying to play a game in which the referee keeps changing the rules.
At the state level, accountants were busy devising a workaround to the $10,000 federal cap on the state and local tax (SALT) deduction. Certain New York corporations and partnerships had until Oct. 15 to opt in to paying New York state tax at the “entity level,” which would allow them to deduct their tax payments at the federal level, essentially bypassing the $10,000 limit.
When the Biden administration released the early details of its tax plan in the spring, it included several proposals that would shape real estate. For one, the Democratic president floated repealing the step-up in basis, a provision that allows families to minimize their taxable gains on properties handed down from one generation to the next.
Biden also sought to close the carried-interest loophole, which allows real estate fund managers to take a portion of their fees at the lower capital-gains rate. And he went after the sacred cow of 1031 exchanges (a handout that always seems to be on the chopping block when tax reform is on the agenda, yet always seems to be spared in the end) by limiting deferrals to no more than $500,000.
Now, the House of Representatives is working on the finer points of tax reform as part of a multitrillion-dollar budget reconciliation package along with Biden’s infrastructure plan. Even the size of the bill — first pegged by the White House at $3.5 trillion — is a moving target, now fluctuating on Capitol Hill somewhere around $1.75 trillion.
One of the primary issues to deal with is proposed changes to the capital gains rate.
The current top rate for high earners is 23.8 percent, a figure the White House wanted to hike up to 43.4 percent for people earning more than $1 million. In the latest round of negotiations, lawmakers appear to have knocked the rate down to 28.8 percent, making it effective on income of $400,000 or more for single filers.
But there’s not much taxpayers can do now to mitigate those increases. When the House Ways and Means Committee put forth its proposal in September, it made the change to the capital gains rate applicable to transactions made after Sept. 13.
That means investors working on deals now will likely be stuck paying whatever rate Washington chooses in the end.
“That’s the biggest question: What is it going to cost me to sell a building?,” said Robert Gilman, co-head of Anchin’s real estate group.
One piece of good news for the real estate industry is that the House nixed Biden’s proposal to scale back 1031 exchanges.
The century-old provision, which allows investors to defer the tax bill on a real property sale by rolling the proceeds over into a new property within 180 days, was designed to encourage reinvestment instead of simply selling properties and pocketing the proceeds. The data suggests it has succeeded on that charge.
A 2020 study by the University of Florida and Syracuse University estimated that 1031 exchanges accounted for between 10 and 20 percent of all U.S. commercial real estate transactions over the last decade.
Opponents argue 1031 exchanges favor wealthy real estate owners. For instance, small-time investors trading stocks are not able to take advantage of similar benefits.
But for many investors, particularly mom-and-pop owners, the tax benefits are often a significant factor in their decision to buy or sell a property. The study found that the median value of properties involved in 1031 exchanges over the ten-year period was just $575,000.
Gilman said he does not expect the 1031 exchange to be eliminated anytime soon. One reason is because states still collect transfer taxes on property sales involved in the exchanges.
“If I am any of the people… from a state that needs money that charges a transfer tax, I am not getting rid of 1031,” he said.
Other parts of the tax proposal have investors thinking about how to hand over their real estate from one generation to the next. The step-up in basis, for example, can mean huge savings for multigenerational owners. It allows them to increase the taxable basis of a property for accounting purposes, which lowers the amount of gains they have to recognize when they sell.
Biden has called for eliminating the step-up in basis for gains exceeding $1 million, calling it a “loophole that allows the wealthiest Americans to entirely escape tax on their wealth by passing it down to heirs.”
Tax experts said the possibility of losing it has more owners thinking about succession and tax planning.
“More people are looking to do estate planning now or actually executing on plans that in the past they have been hesitant to deal with,” said Meyer Mintz, co-leader of the real estate group at Berdon.
For clients looking to avoid potentially higher taxes when they pass down real estate, his advice is simple: “Gift it now.”