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How the Biden tax proposals might impact your real estate business: Part 2

May 20, 2021

Click here to read part 1.

While the Biden administration’s proposed tax changes are so broad that they will affect almost all taxpayers in some way, this article specifically focuses on what in those proposals would most significantly impact the real estate industry.

Part 1 of this article addressed the reduction of like-kind exchange benefits under Sec. 1031, the reduction of the step-up in asset basis at death and the reduction of the 20% QBI deduction benefit for rental real estate. This article will address the proposed increase in capital gains rates, taxation of carried interests at ordinary income tax rates, the limitation on the deduction of business losses, as well as the potential effective date of any law change.

Raising capital gains rates

The Biden administration has proposed that taxpayers earning more than $1 million pay ordinary income tax rates on their long-term capital gains, rather than the more favorable 20% rate that currently applies.

  • This steep increase is unlikely to occur. Many economists believe that a capital gains rate that is too high will actually decrease tax revenue, because taxpayers will either delay the sale of property or will utilize provisions in existing tax law to defer their gains (such as like-kind exchanges under Sec. 1031 or investments in Opportunity Zone Funds).
  • Since the goal of increasing capital gains rates on upper-income taxpayers is to generate additional tax revenue (in addition to the favorable optics of a tax increase perceived to be borne primarily by the wealthy), the expectation is that a capital gain rate in the 25-30% range is probably more likely.
  • The 3.8% surtax on net investment income that currently applies would also apply on top of the increased capital gain rate.
  • Not only does the capital gain rate apply to property held for investment, but it also applies to gain on the sale of property used in a trade or business or for the production of income (such as rental real estate).

Taxation of carried interests

Under a special provision in the tax code, the gain a partner recognizes related to their ownership of a carried interest (also known as a profits interest or sweat-equity interest) has historically been taxed at favorable long term capital gains rates. However, an abundance of negative publicity regarding the use of this perceived “loophole” by the private equity and hedge fund industries resulted in the TCJA imposing a three-year holding period for certain carried interests in order to obtain long-term capital gain treatment

The American Families Plan would close this carried interest loophole completely, imposing ordinary income tax rates on all income and gain from carried interests.

  • It is important to note that if capital gains rates are increased to equal ordinary income tax rates, carried interests would automatically be subject to ordinary tax rates; however, by eliminating this provision in the tax code, any future reductions in capital gains rates below the ordinary tax rate amounts would not automatically benefit carried interests.
  • Since many real estate partnerships are structured to provide the developer with a carried interest, this change would have a significant impact on the expected economics of many existing deals if the proposal is passed without any grandfather provisions (which is what happened when the holding period for capital gain treatment was increased to three years).

Limiting the deduction of business losses

The TCJA created a new tax provision limiting individual taxpayers’ annual deduction of net business losses to $250,000 ($500,000 for married taxpayers filing jointly). Any losses in excess of this annual limit are not lost — they are instead carried forward to future tax years, where they are classified as net operating losses and their use may be further limited.

This new limitation was originally scheduled to be effective for tax years beginning after December 31, 2017 and before January 1, 2026. However, the limitation was temporarily eliminated by the CARES Act — retroactively for tax years 2018 and 2019 (requiring taxpayers who had already filed their returns and applied the limitation to amend those prior year returns or lose the deduction permanently) and prospectively for tax year 2020.

The American Rescue Plan then extended the loss limitation for an additional year, through 2026.

  • The Biden administration has now proposed to make the limitation permanent.
  • With the TCJA’s increase in bonus depreciation from 50% to 100%, many real estate owners are able to generate significant rental losses when acquiring new properties, substantially renovating existing properties, or building out tenant improvements.
  • Unfortunately, this business loss limitation can limit those owners from receiving an immediate tax benefit from those depreciation-generated losses.
  • This would be the third change in the excess loss provision in only two years, demonstrating Congress’ willingness to use the loss limitation provision as a tool to raise revenue and the likelihood of the limitation being made permanent.

What’s next?

Not surprisingly, bipartisan politics will likely prevent the Biden administration from achieving all of this. Republicans want a much smaller plan than the president’s $2 trillion infrastructure plan (American Jobs Plan), which could be dealt with by utilizing a bill under reconciliation, which could pass with only Democratic votes. But there are some Democrats that have indicated that they won’t vote for a tax package unless it repeals the $10,000 cap on deductions of state and local taxes. Biden’s current proposal does not address this cap, but future inclusion is still a possibility.

As for timing and potential effective date of any changes that ultimately become law, Speaker Nancy Pelosi has optimistically indicated her goal of getting the American Jobs Plan and the American Family Plan passed by July. The longer expected negotiations continue, the tougher things likely become, due to the impact of looming mid-term elections.

In addition, the later the changes become law, the more likely they will have a prospective effective date of January 1, 2022 (although certain changes could still be given an effective date in 2021).

Wipfli will continue to monitor these proposals and issue guidance as further details are provided. Note that the Treasury is expected to issue what is referred to as its “green book” by the end of May. This green book will contain significant detail regarding all Biden administration tax proposals issued to date.

But don’t wait until these proposals have become law to start thinking about how they will impact you, your business and your future deals. If you have questions or would like additional information, please contact us. We are here to help.

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Author(s)

Crystal Christenson, CPA, MST
Partner
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