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How Biden’s Tax Plan May Affect Real Estate Investors, Developers

Posted on May 18, 2021

President Biden’s $1.8 trillion American Families Plan intended to help low- and middle-income families “cover basic expenses, lower health insurance premiums and reduce childhood poverty” calls for significant changes to the tax code, including higher tax rates and fewer loopholes for wealthy taxpayers. As Congress now debates whether any of the provisions included in the president’s proposal will ultimately pass into law, real estate developers and owners should take notice.

Tax Increases  

The administration proposes to increase the top tax bracket to the pre-2018 level of 39.6 percent and apply the same tax rate to long-term capital gains and qualified dividends for individuals with income of more than $1 million. While the administration’s tax agenda makes no mention of changing today’s very generous estate-tax exemptions, it does aim to eliminate the practice of stepping-up the tax basis of inherited property to the fair market value at the time of the owner’s death. Consequently, heirs would be required to pay tax on the appreciated gains of a decedent’s property valued above $1 million (or $2.5 million per couple).

As an example, consider a commercial property an investor purchased for $1 million in 2000 is today valued at $5 million. If the investor sells the property today, he or she may have a 20 percent long-term capital gains tax (plus a 3.8 percent Medicare tax) on the $4 million gain. If the investor passes away, the property transferred to the heir would receive a step-up in tax basis to today’s market value of $5 million and avoid any capital gains tax indefinitely on the $4 million of appreciation.

By contrast, under Biden’s proposal, the investor would be subject to a 39.6 percent tax on the capital gain (plus a 3.8 percent Medicare tax) resulting from a property sale during the investor’s life. If the investor holds onto the property and passes away leaving it to his or her heirs, the transfer will be treated as a deemed sale, and their heirs will need to pay the capital gains tax on the property’s appreciation, less the $1 million or $2.5 million exemption, that occurred before they received their inheritance.

1031 Exchanges  

The president’s recent tax proposal also aims to put an end to Internal Revenue Code Section 1031 exchanges, which real estate owners and investors have long wielded as a powerful, tax-advantaged tool for growing their portfolios and building wealth. In a 1031 exchange, a taxpayer may defer tax on the gains generated from a property sale when they reinvest the sale proceeds into a similar property of equal or greater value. This essentially has allowed taxpayers to sell long-held, highly appreciated investment property free of federal and state income taxes and allow their original investment dollars to continue to grow tax-deferred. Under Biden’s plan, however, the tax-deferral benefits of 1031 like-kind exchanges would apply only to sales generating a gain of $500,000 or less.

The prospect of increased tax rates on capital gains and a limit on 1031 exchanges may spur some property owners to expedite sales before a new law would take effect. However, taxpayers should first meet with their advisors and CPAs to weigh the pros and cons of such action. In some instances, property owners may avail themselves of other, more tax-efficient planning strategies, or they may simply wait it out, depending on their unique circumstances.