On April 7, the US Treasury Department released a nineteen-page document outlining some of the key provisions in President Biden’s Made in America Tax Plan. In the weeks since, additional provisions and guidance have been released and discussed.
While the effects of the proposed tax changes are different for each industry, they will undoubtedly impact commercial real estate in Florida. This article analyzes a few of the key proposed changes affecting property owners in the state of Florida.
Section 1031 Exchanges
One of the most talked-about proposed changes in President Biden’s tax plan is the elimination of certain Section 1031 Exchanges. Tax-deferred Exchanges have been a part of the US Tax Code since the early 1920s.
Sellers who reinvest the proceeds from a property sale can defer paying taxes on the gain associated with the sale. Incentivizing taxpayers to reinvest in real estate is a way to spur economic and community growth.
President Biden’s plan calls for eliminating Section 1031 Exchanges on real estate profits of more than $500,000. According to The Tax Foundation, a non-profit tax research organization, repealing Section 1031 Exchanges for amounts over $500,000 would raise $7.5 billion in tax revenue over the next ten years.
While this sounds like a lot of money, compared to the other proposed tax changes, the financial impact for the US Treasury is relatively small. Real estate practitioners and national real estate organizations have already opposed this proposed change to Section 1031.
Because tax-deferred exchanges have been in existence for 100 years and the relative increased taxable revenue is quite minimal, we are hopeful that any tax reform passed in the coming months excludes any changes to Section 1031 Exchanges.
Capital Gains as Ordinary Income
Arguably the most talked-about change in President Biden’s plan is taxing long-term capital gain income at ordinary income tax rates for taxpayers making over $1 million.
The current top long-term capital gains rate for individuals is 23.8% (20% capital gain rate plus the 3.8% surtax). Under President Biden’s plan, the top long-term capital gain tax rate would be a combined 43.4%.
This rate would apply to 0.3% of households (projected around 500,000). Short-term capital gains on assets held for less than one year are already taxed at ordinary income tax rates for individuals.
For C-Corporations, capital gain income (both long-term and short-term) is already taxed at the ordinary income corporate tax rate of 21%. One of President Biden’s plans is to increase the corporate tax rate. Therefore, we would expect the tax applied to capital gains for C-Corporations to increase the new corporate tax rate.
The financial impact on Treasury tax revenue relates directly to how capital gains are treated at death, which we will discuss next in the section “Estate Tax Changes.” If capital gains are taxed without a stepped-up basis at death, then the proposed tax increase would increase federal government revenue by $113 billion over ten years, according to the University of Pennsylvania’s Wharton School of Business Budget Model.
Should capital gain tax rates increase, transaction volume in commercial real estate might decrease because sellers do not want to pay the high tax rate on a potential sale. Demand might increase as investors seek longer-term investments such as commercial real estate (compared to short-term stock investments).
Some commercial real estate experts predict that property owners might pass the higher tax on a planned future sale to tenants via higher rent prices. One benefit to owning property in the state of Florida as an individual or flow-through entity is there isn’t an additional state capital gain tax applied on a potential sale. More investors might look to invest money in states only subject to federal taxes as a way to minimize their overall tax bill.
Estate Tax Changes
In 2018, the estate tax exemption more than doubled per person – from $5,490,000 in 2017 to $11,180,000 in 2018. This change was precipitated by President Trumps’ Tax Cuts and Jobs Act of 2017.
For a married couple who passed away in 2018, they could pass down up to $22,360,000 worth of assets to their heirs without paying any estate tax. Further, the property heirs would not owe tax on the receipt and would receive a stepped-up basis in the assets to the fair market value of the assets on the date of death of the owners.
President Biden’s tax plan proposes two fundamental changes: a reduction of the estate tax exemption to $3.5 million per person (which was the exemption amount in 2009), and recipients of estates with gains above $1 million would pay capital gain taxes on the receipt. These recipients would not receive the “stepped up” basis at death.
The interplay between the estate tax, stepped-up basis, capital gain, and Section 1031 Exchange changes is interesting. Many commercial real estate property owners will do Section 1031 Exchanges on properties until their death because they know at that point, their heirs will receive the property with a stepped-up basis and never owe taxes on the deferred gain.
Additionally, heirs often won’t have to pay estate taxes on the properties at death because the taxable estate is less than the exemption. President Biden’s tax policy changes this strategy.
In summary, the potential impacts of President Biden’s tax proposal on this common tax strategy are:
- If the estate tax exemption drops, taxes might have to be paid on the transfer at death.
- If the stepped-up basis at death provision is eliminated, capital gains will have to be paid by heirs on many properties.
- If the highest long-term capital gain tax rate is increased to 43.4%, high-income taxpayers might have to owe a substantial amount of tax on an inherited property.
- If the Section 1031 gain is eliminated, taxpayers won’t be able to defer taxes until death, and the majority of this strategy goes away.
Will all of these changes be passed in their current form? Probably not. However, the tax strategies employed by high-net-worth property owners might be severely impacted by changes in tax law.
SALT Deduction – Might Slow Movement to Florida
President Trump’s Tax Cuts and Jobs Act of 2017 limits taxpayers to deducting $10,000 of state taxes paid on their federal tax return. The state tax deduction includes property taxes, sales taxes, and income taxes. This limitation negatively impacts residents in high-tax states, such as California, New York, and New Jersey, because their federal tax deduction is limited.
Both Republican and Democratic representatives from these states have spoken out against this limitation and want the policy changed as part of President Biden’s plan. However, in its current version, President Biden’s plan keeps the restriction in place.
The political dynamics of this item will be fascinating to watch moving forward. Do Democratic Senators and Representatives from these states cave to pressure from their party to pass a tax reform bill without modification? Or, in an already gridlocked Senate, do they refuse to pass the bill without a change to this limitation?
Some residents of high-tax states are already moving to non-tax states such as Florida and Texas. This trend has only intensified as a result of COVID-19. The SALT limitation only makes low-tax and non-tax states more attractive to residents of these high tax jurisdictions.
Population and demographics drive commercial real estate. The state of Florida’s commercial real estate industry has benefited. Will there be a change to this deduction limit? From both a political and policy perspective, this will be interesting to watch, and the outcome could have an impact on Florida’s population growth.
It is important to remember that we are still at the early stages of President Biden’s plan. What actually will pass (if anything) will look different than the current proposal.
However, taxpayers and property owners should stay informed and begin planning with their tax advisors to consider the potential impacts. Our team at SVN | Saunders Ralston Dantzler will continue to publish additional guidance as it becomes available.
This article should not be construed as and should not be relied upon as legal or tax advice. Readers should consult their tax advisor.
Meet the Expert
Tyler Davis brings a wealth of financial knowledge to the team, having spent over five years working at PwC, one of the largest professional services firms in the world. While there, Tyler provided tax planning and consulting services to some of the largest public and private insurance companies in the country. Tyler worked on several mergers and acquisitions while at PwC with total transaction volume in excess of $9.1 billion.
Call Tyler today at 863-877-2829 or email him at firstname.lastname@example.org.