Any time party control in U.S. government flips is an interesting one from a tax perspective, as each party brings with them a competing tax philosophy. When Republicans gained control last election cycle, they quickly got to work, passing the Tax Cuts and Jobs Act of 2017, or TCJA. This year, the Democrats appear poised to pass tax reform of equal magnitude, as they seek to undo the work of the TCJA and implement some bold new approaches of their own.
Real estate may be impacted under a Biden presidency, as the Democrats seek to raise revenue to pay for a variety of new anti-poverty and clean energy programs, among others. Congressional Democrats are not alone, either. California state lawmakers have recently come out with several tax proposals that, if passed, could greatly impact taxation on real estate. Here are 10 proposals to monitor.
1. Return the top marginal tax rate to 39.6%.
Currently, the highest marginal tax rate on personal income is 37% (currently $518,400 for single tax payers in 2020). Current proposals would return the top marginal tax rate to its pre-TCJA rate of 39.6%, and lower the threshold at which it kicks in to $400,000.
2. Tax long-term capital gains at the ordinary rate for individuals with income over $1 million.
Currently, the highest rate individuals must pay on long-term capital gains — the tax category into which gains from real estate typically fall under — is 20% for Federal Income Tax. That rate applies to single taxpayers with taxable income above $441,450 in 2020. Under current proposals, taxpayers with an annual income in excess of $1 million would see long-term gains taxed at the taypayer’s ordinary personal income tax rate. This means that affected tax payers could see their capital gains (such as gains on sale of real estate) taxed at the proposed top marginal tax rate of 39.6% — nearly twice the rate they have paid since the TCJA came into effect in 2018.
3. Restrict like-kind exchanges.
Section 1031 of the U.S. Internal Revenue Code currently allows real estate investors to defer capital gain taxes on the sale of certain investment property if the proceeds were reinvested in another property. Current proposals would eliminate limit annual deferral of gain though real estate like-kind exchanges to $500K individuals/$1M couples, effective for exchanges completed in tax years beginning after 2021.
4. Phase out the Section 199A deduction for income over $400,000.
Certain real estate income is eligible for the Section 199A Qualified Business Income deduction which can allow a deduction that can be as much as 20% of the income from the activity. Current tax proposals would phase out the pass-through tax deduction for individuals with more than $400,000 in taxable income.
5. Tax Unrealized Gains at Death
The Biden administration is proposing a tax on unrealized gain of an appreciated asset when transferred by gift or death. Tax to be assessed to decedent/donor, and recipient’s basis will be Fair Market Value. There will be a $1 million exclusion (portable to the spouse), a $250K principal residence exclusion (also portable to the spouse), but no tax for certain “family owned businesses”.
6. Eliminate the $25,000 exemption from passive loss rules.
While most tax proposals have been targeting high earners, at least one change is aimed at smaller real investors. Currently, individuals with an annual modified adjusted gross income of less than $150,000 can make use of a special rental real estate allowance to deduct as much as $25,000 of passive real estate losses against non-passive income (i.e., investment income/wage income/et al) as long as they are active participants in the rental real estate activity.
Current tax proposals would eliminate this benefit.
7. Expand Reach of 3.8% Net Investment Income Tax and Self-Employment Taxes for income over $400K.
Net Investment Income tax extended to taxpayers that actively participate, including real estate professionals. Self-employment tax extended to limited partners, LLC members and S-Corporation shareholders who materially participate.
8. Introduce a renter’s tax credit.
Renters, which make up around a third of Americans, have not been forgotten. Current tax proposals are calling for a new renter’s tax credit, that would provide assistance to low and moderate income individuals that pay more than 30% of their pre-tax income on rent and utilities. This credit would not only provide major assistance to lower-income Americans, but it could also entail more consistent rental income for certain investors and developers.
9. Increase California’s top tax rate for individuals from 13.3% to 16.8%.
At a rate of 13.3% on income over $1,000,000, California residents with high net worth already experience the highest top marginal tax rates in the country. Some state lawmakers want to push that rate even higher, however. While the effort during last year’s legislative session failed, the state could see the bill (or a similar one) reintroduced in 2021.
10. Make California the home of the country’s first ever wealth tax.
There has been discussion over a controversial proposal to begin taxing the fortunes of California’s very wealthy. The bill also failed during last year’s legislative session, but if the bill were to pass in a future session, it would impose an annual tax of 0.4% on the net wealth of California-based individuals over $30 million. Not only that, the tax would follow individuals for 10 years, regardless if their primary residence is no longer in the state. However, this tax, like the proposal to raise the top marginal California tax rate, could precipitate an exodus of wealthy individuals to other, lower-tax states.
BPM Tax Services for Real Estate Investors
Keeping up with the changes in the tax code can be daunting even for full-time real estate investors. Thankfully, BPM is skillfully positioned to provide tax planning services to those in the real estate industry, such as investors, developers, managers, REIT, and family-owned real estate enterprises. Our real estate accountants understand the regulatory and business challenges facing your industry and are dedicated to staying ahead of the curve to help you navigate a changing environment. Our experience enables us to assist you with even the most complex real estate tax scenarios. To learn more about how BPM can support your real estate investments, contact BPM Managing Director Paul Fong today.