Last week, President Biden formally announced the details of his next wave of legislation called the American Families Plan. As anticipated, the plan to help low- and middle-income families is set to be paid for with tax increases for wealthy Americans and corporations. The American Families Plan’s potential impact on real estate could be felt in a few different ways, from a potentially higher capital gains tax rate to a new threshold for like-kind exchanges.
The legislation will go through several rounds of revisions before it’s finalized. In the meantime, the proposal does offer more concrete details that high-net-worth taxpayers and real estate stakeholders can use to start mapping out alternative tax planning strategies.
What’s in the American Families Plan?
The American Families Plan calls for substantial investments in education, families, and children. Some of the biggest line items in the plan include universal preschool for three- and four-year-olds, two years of free community college, and subsidized tuition for students enrolled in Historically Black Colleges and Universities (HBCU), Tribal Colleges and Universities (TCU), and other Minority-Serving Institutions (MSI) whose families earn $125,000 per year or less.
Other cornerstones of the plan are extended and expanded tax credits mirroring the recently passed American Rescue Plan Act. Making permanent the healthcare tax credit, child and dependent care credit, and the earned income tax credit for childless taxpayers. Under the proposal, the child tax credit, which was expanded in the American Rescue Plan for 2021, would be extended at its current rate through 2025 and made fully refundable thereafter.
Other proposals in the American Rescue Plan include implementing a paid family leave under FMLA over ten years, capping the cost of childcare for certain families, providing extra funding to community colleges, expanding Pell grants, and much more.
To pay for the plan, Biden has proposed the following:
- Reinstate the top income tax rate for taxpayers making more than $400,000 per year to 39.6 percent
- Increase the highest capital gains tax rate for taxpayers making more than $1 million per year to 39.6 percent
- Apply the 3.8 percent Medicare tax uniformly to all taxpayers making more than $400,000 per year
- Increase IRS enforcement against wealthy taxpayers
- Cap 1031 exchanges for real estate gains at $500,000
- Remove the step-up in basis for gains more than $1 million, or $2.5 million for couples
- Tax carried interest income allocations as ordinary income versus capital gains
- Extend permanently excess business loss limitation under section 461(l)
Impact on the Real Estate Industry
Besides the obvious implications for a higher ordinary tax rate, increasing the capital gains tax rate would have implications for the real estate industry. The proposed increase is substantial: from its current 20 percent to 39.6 percent for taxpayers making more than $1 million annually. This does not include the 3.8 percent net investment income tax, which when combined would potentially mandate taxpayers in the million-plus income range pay a total of 43.4 percent on capital gains. It is unclear at this point what kind of income is included.
Comparatively, U.S. taxes represent about 24 percent of gross domestic product, compared to an average of 34 percent for other high-income countries; yet U.S. tax revenue is comprised of more income and profits taxes – including capital gains – than in most other countries. Though proponents say that the higher capital gains rate would only apply to about 500,000 U.S households, which represents less than one percent of all taxpayers.
Real estate investors have been eyeing the potential elimination or reduction of 1031 exchanges for months and now there is a proposal to curtail the popular tax strategy. A 2015 EY report identified several challenges for repealing like-kind exchanges, including a higher tax burden, longer holding periods, and increased debt financing. These effects are still likely to be seen if the proposal to limit like-kind exchanges is passed.
Eliminating Step-Up in Basis
Currently, unrealized gains at death can be passed on to heirs, thus deferring taxes until the property is later sold. The step-up in basis is secured and readjusted at the time of death. According to the Joint Committee on Taxation, this tactic saves U.S. taxpayers about $41 billion per year. The American Families Plan proposes eliminating the step-up in basis and recognizing the date of death as a taxable event. This change would treat assets like a home or business as a sale rather than inheritance and would be taxed proportionately at the time of death.
Family-owned businesses and farms would be exempt provided the heir keeps running the business.
Many of the other tax proposals in the American Families Plan could impact the real estate industry in some way, from eliminating the loophole for carried interest to the expanded 3.8 percent Medicare tax. Much remains unclear and the specifics can change between now and when the bill is eventually made law. There are still tax strategies to help real estate investors and other taxpayers navigate new rules, whatever they may be.
Research indicates that when tax policy is changed, real estate investor behavior changes along with it. For example, if long-term capital gains rates are eliminated, alternate strategies could include installment sales, seller financing, higher rents, fewer capital projects, and deferring strategic maintenance projects. Or there is the option to pursue international investments.
PBMares will continue to monitor developments surrounding the American Families Plan and its potential impact on the real estate industry. In the meantime, contact Jennifer French, CPA, Partner and Team Leader of PBMares’ Construction and Real Estate group, for questions.