The Biden Administration is signaling that it will start efforts to overhaul the Tax Code in such a way as to increase taxes and unwind the Trump Administration’s Tax Cuts and Jobs Act. Without belaboring the details of the entire tax plan and discussing matters not relevant here, I want to focus on two targets of the Biden proposals: the 1031 Exchange and Capital Gains.
The 1031 Exchange
Real estate, especially in the multi-family and commercial space, relies heavily on the ability to defer capital gains from the sale of property. This is done by allowing the seller to swap one piece of real estate for another and reduce or obviate that capital gain on the sold property. To say this tax provision is popular would be an understatement. Recent IRS regulations outline what constitutes real property for 1031 eligibility — these regulations would now become moot. (Currently, Section 1031 requirements are: 1) real property must be exchanged for like-kind real property, and 2) the property relinquished in the exchange and the replacement property received in the exchange must both be held for business or investment purposes.)
The Biden Administration also is looking to terminate the step-up in basis that alleviates beneficiaries of large tax liabilities on inherited assets that have increased in value. Those inherited assets sold by the beneficiary would require capital gains to be paid on the original basis at the time of purchase as opposed to the fair market value at the time of inheritance. Thus, inherited assets that have been part of a 1031 exchange would have a minimal tax basis given the capital gains tax deferral on gain recognition. Eliminating the step-up in basis would trigger deferred gain liability.
In conjunction with the 1031 exchange being eliminated, the Biden administration’s tax proposals are taking aim at capital gains rates, too. This means, that instead of paying the 20% capital gains rates (23.8% for high earners) for the sale of property held for investment for a year or more, the administration is going to increase that rate. The proposal being floated by this administration is to raise the capital gains rate to 39.6%, which is the top tax bracket under the Biden tax plan for individuals. Thus, capital gains rates have been eliminated and all gains are now ordinary gains.
What Does This Mean for Real Estate?
To be blunt, this is a BIG problem for real estate investors. The tax benefits that encourage investment in real estate are being eliminated. Moreover, the far-reaching impact of these two tax provisions would chill real estate investment. This is something many of us in the investment community need to monitor. Nothing has happened yet, but with the policies being pushed through Congress and the Senate along partisan lines, real estate is in the crosshairs at the moment.