The ability of presumed President-elect Joe Biden to pass sweeping tax reform hinges on the results of two Senate run-off races currently taking place in Georgia. If Republicans clinch one of the two seats, it is unlikely that Democrats will have the votes needed to pass their proposed tax law changes. If Democrats can secure the two seats in Georgia, they will split control of the Senate with Republicans, but would have presumed Vice President-elect Kamala Harris’s tiebreaker vote, if needed, to pass a proposed tax plan. But the run-off election in Georgia isn’t scheduled until January 5, 2021, which is too late to implement many traditional strategies to reduce 2020 taxes.
The topics below highlight the proposed changes which could have a significant impact on the real estate industry. It is important to be aware of how the application of these potential changes can affect your specific circumstances.
Increase Highest Tax Rate
The current maximum tax rate as passed through the Tax Cuts and Jobs Act (“TCJA”) is 37%. Biden’s tax plan would push to increase the maximum tax rate back to the pre-TCJA rate of 39.6% for taxpayers earning more than $400,000 (unclear if this will be applicable for individuals, families, or both).
In addition to increasing the highest tax bracket, Biden has proposed additional Social Security taxes on taxpayers earning $400,000 or more. Currently, the Social Security tax (combined 12.4% for employers and employees) is imposed on the first $137,700 of an employee’s wages, with the remaining income not subject to Social Security taxes. Under Biden’s tax plan, he would likely seek additional Social Security taxes on earnings in excess of $400,000, thus creating a gap where wage income between $137,700 and $400,000 would not be subject to social security taxes.
Long Term Capital Gain and Dividend Rates
Under his proposed tax plan, Biden seeks to increase the long-term capital gain and qualified dividend tax rates. Currently, this income is taxed at a maximum rate of 20% (plus 3.8% net investment income tax). Biden’s plan would increase the maximum rate on long-term capital gains and qualified dividends to 39.6% (or 43.4% with the 3.8% NII tax) for those who earn $1 million or more, essentially taxing it at ordinary income rates. It has not been specified whether the $1 million income determination will be based on gross, adjusted, or total income amounts.
The TCJA retained preferential long-term capital gain treatment for carried interest when capital assets are held three years or longer. With Biden’s proposed plan eliminating capital gain treatment for those earning $1 million or more, the aforementioned treatment would ultimately revert taxes on carried interest back to the higher ordinary income tax rates. Real estate assets that are developed and leased (§ 1231 assets) continue to fall outside of these carried interest rules and maintain their more favorable one year hold requirement.
20% Qualified Business Income Deduction
The 20% qualified business income deduction passed through the TCJA has been a favorable deduction for those with pass-through income in industries such as real estate. Under Biden’s proposed tax plan, the deduction would be phased-out for taxpayers with income in excess of $400,000 and eliminated for rental real estate activities. The net impact would increase the current effective tax rate of 29.6% to as high as 39.6%.
Biden’s proposed tax plan would also include restoration of the pre-TCJA phase-out limitation on itemized deductions for taxpayers earning greater than $400,000 a year. A taxpayer’s total itemized deductions would be reduced 3% for every dollar of income that exceeds $400,000. Additionally, the President-elect has proposed capping the benefits of itemized deductions at 28% for those making over $400,000.
The President-elect’s tax plan has proposed significant increases for several existing tax credits such as the Child Tax Credit and Child and Dependent Care Credit. It also proposes new credits for those providing care to elderly relatives, first time home buyers, and low-income renters. Tax credits can offset potential income taxes dollar-for-dollar and in certain cases can be fully refundable. However, most credits have income limitations and those exceeding the $400,000 income threshold would likely not be eligible for these credits.
In order to fund his proposal for increased child tax and elderly care credits, Biden has proposed closing “loopholes” for property investors and hinted toward the elimination of like-kind (“1031”) exchanges being an area to do so. 1031 exchanges are used by investors to defer capital gain recognition and encourage continued investment in the real estate market. 1031 exchanges have been targeted before in previous tax law changes, but the economic importance of such exchanges has overshadowed previous attempts to eliminate them.
Biden also aims to end the current step-up in basis that spares beneficiaries substantial tax liability for capital gains on inherited assets that have appreciated in value. Inherited assets sold by a beneficiary would generate capital gains tax based on the asset’s original cost basis at the time of purchase, rather than the fair market value at the time of inheritance. Inherited assets that have previously been part of a 1031 exchange typically have a very minimal tax basis given the deferral of gain recognition, and thus a step-up in basis under current law eliminates any previously deferred gain from ever being recognized.
While there are currently no plans to eliminate the opportunity zone program, Biden has proposed increased regulations, including review by the Treasury Department to ensure clear “economic, social and environmental benefits”. He has also suggested that investors be required to make public disclosures about their investments. Additional regulations could negatively impact potential investors from making further investments in opportunity zone funds.
Biden’s proposed increase in capital gain tax rates may also have a negative impact as current gains are deferred and taxed at a potentially much higher rate in 2026. On the other hand, an increase in capital gain rates would make the tax free exit from an Opportunity Zone investment more attractive assuming the increased rates are still in place after the required 10 year holding period.
Estate taxes could see significant changes under Biden’s proposal, including an increase to bring the estate tax to 45%, lowering the exemption level to $3.5 million for individuals (currently $11.58 million) and eliminating step-up basis at the taxpayer’s date of death. As previously mentioned, the elimination of step-up basis could leave taxpayers with significant capital gains that would be recognizable upon their death, and if combined with the proposed ordinary income rates on capital gains for high income individuals, could mean a significant increase in taxes upon a person’s death.
While this article does not include all of the changes that have potential to impact the real estate industry, it is important to begin to understand how these changes can affect each individual’s circumstances and steps that should be taken now. Specifically planning for the proposed changes to estate taxes for high net worth individuals, is warranted.
With the federal budget deficit now over $3 trillion and the need for additional stimulus spending due to the COVID-19 pandemic, new tax laws could face an uphill battle, regardless of Senate control. We will keep you up-to-date on the developments that could affect your personal and professional bottom lines. Our Elliott Davis tax advisors are happy to assist with any specific questions or needs.
The Electoral College will certify the election results by December 14, 2020. There also are some ongoing state recounts and legal challenges. The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.