President Biden has proposed an increase in long term capital gains from their current 15-20% to 43% for the wealthiest.  This would be the highest tax paid on income.  What is in the new proposal?  What does this proposal mean for real estate?  How will the 1031 exchange be impacted?  Why will farms and commercial properties be impacted the most from this proposal?

What is in the new Biden tax proposal?

There are several items in the new tax plan, but I wanted to focus on the increase in capital gains tax for the purpose of this article as this will have the largest impact on real estate.  Under president Biden’s proposal, he would raise long-term capital-gains tax for the wealthiest Americans to 43.4%, including a surtax. That would be higher than the top federal tax rate on wage income. This tax rate would apply to assets held in taxable accounts and sold after more than a year.

With the increase in the long-term capital gains rate, long term gains and short-term gains would be treated equally with both essentially being taxed at much higher rates.  Historically short-term capital gains rates were set substantially higher to discourage short-term investing and reward longer term horizons.

What does the new tax mean for the real estate?

Currently real estate would be a giant loophole because of the 1031 exchange.  Under the current law, gains on real estate can be deferred with the purchase of a like asset.  For example, let’s say you had a rental house that you purchased for 250,000 10 years ago that is now worth 650,0000, when you sell you have 400,000 + any depreciation you took over the years as a “gain”.  You can go buy another property and roll the 400k in profits into the new property and pay no taxes.

The way the law is currently written now, real estate will be a huge loophole in the tax law as investors will flood into real estate so that they do not have to pay a 43% capital gains tax when they sell the asset.  On the example above, if the scenario were now that someone bought 250k in stock that was now worth 650k, the tax bill would be $172k when the stock was sold.  Real estate, even with a lower long-term return, will be a much better avenue than stocks because of the tax hit.

Along with the 1031; the other major change to real estate is that taxes are due and payable on death.  Today, you only pay taxes on inherited assets like real estate when the asset is physically sold.  Under the new plan, death is a taxable event.  For example lets assume you worked in a family farm that was worth 5 million for the land as it had been in the family for generations.  When the current owner dies, there would be a huge tax bill to the tune of 2.2 million dollars.  Unfortunately land is not like a stock that can be easily broken up and sold as it is an operating business.  The current tax proposal would destroy large land owners along with commercial property owners.

Will the 1031 exchange survive the new tax plan?

If the Biden tax plan is approved as written today, I suspect they will close the “1031 loophole” by subjecting real estate to the same tax rates as long-term capital gains.  The most recent proposal is that the 1031 would be eliminated for anyone making more than 500k/year.  I don’t see how the 1031 could survive with long term capital gains being taxed so much.

What happens to real estate and stocks with a huge increase in long term rates?

It is interesting that the writers of the new tax plan talk about huge increases in revenue.  The assumption is that behaviors (like selling an asset) will stay the same with the new rate.  Unfortunately, this analysis could not be farther from the truth.  With a top rate of 43% people will delay selling the assets as long as possible.  For example, if you owned the rental property used in the example above, you would likely make the decision not to sell the property if you had to pay 43% in taxes.  If you needed cash, you could refinance the property to pull some cash out.

Summary

Fortunately, the tax plan is not a done deal. There will be considerable lobbying on both sides of the aisle to reduce this rate.  I suspect the long-term rate to end somewhere around 30% or less and other changes to the tax plan to be altered as well.  I do think we will see changes to the 1031 with some sort of an income cap to be able to utilize a 1031 exchange.  Unfortunately, as taxes go up people will change their behavior to optimize their returns.  As with everything in economics, there are always unintended consequences. The proposed tax plan would drastically reduce liquidity in the marketplace and raise considerably less taxes than previously thought.

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Written by Glen Weinberg, COO/ VP Fairview Commercial Lending.  Glen has been published as an expert in hard money lending, real estate valuation, financing, and various other real estate topics in Bloomberg, Businessweek ,the Colorado Real Estate Journal, National Association of Realtors Magazine,  The Real Deal real estate news, the CO Biz Magazine, The Denver Post, The Scotsman mortgage broker guide, Mortgage Professional America and various other national publications.

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