How Biden’s Tax Plans Will Impact Real Estate Investors
With Joseph Biden and Kamala Harris winning the 2020 Presidential election, many real estate developers and investors will be wondering how the results of this election may impact their business models, if at all. The last several years have seen significant tax reform, regulations, and changes as a result of both the Tax Care and Jobs Act (TCJA) of 2017, and the Coronavirus Aid, Relief, and Economic Security (CARES) Act of 2020. Many of these changes have been positive for real estate investors and developers, including Qualified Opportunity Zones, bonus depreciation rules, qualified improvement property, the qualified business income deduction, and numerous others. President-Elect Biden proposed a number of provisions on the campaign trail that would alter some previously enacted provisions, expand certain programs, or eliminate provisions previously used by real estate investors and developers.
Note that before most of his plans could be implemented, a bill would need to be introduced, debated, and passed by the House of Representatives, and the Senate, before ultimately being signed into law by the president. There are some runoff elections scheduled for January, but many predict that the Republican Party may continue to hold a majority in the Senate. If true, any tax reform that would make it to the president’s desk would need to be a bipartisan affair. In short, the policies described below represent the Biden / Harris wish list – we may see some, none, or all of these provisions eventually in place depending on the outcome of the Senate elections and the legislative process.
Tax Increases and New Taxes
The Biden Tax Plan includes several new and increased taxes on individuals and businesses, which will have a direct impact on investors and developers as they consider their true returns on investment in projects, from operations through the ultimate sale.
The simplest of these proposed changes is returning the top individual tax bracket from 37% (initiated under the TCJA) back to 39.6%. As of this writing, it has not been made clear at what income level this rate would apply (will existing brackets be retained?) the top corporate rate is proposed to increase to 28%, up from the current flat rate of 21%.
The Biden tax plan imposes a 12.4% payroll tax and self-employment tax on wage and self-employment income that exceed $400,000. The current law imposes the 12.4% social security tax on wages and self-employment income up to $137,700, which would remain in place. Thus, we would have a ‘tax gap’ of income from $137,701 to $399,999 that would not be subject to the new 12.4% tax, while wages and self-employment tax above and below that range would be subject to this new employment tax. (The lower number is indexed for inflation while the cap would not, so this gap would shrink over time.)
This change would not greatly impact real estate investors who attain the majority of their income from real estate rentals, which are normally per se passive and not subject to self-employment taxes. For a developer, flipper, wholesaler, or for many other forms of income within real estate, the income generated is ordinary and may be subject to self-employment tax. The author believes that this change (if implemented) would bring back S-Corporations as a favored way to shelter a portion of income from the new 12.4% tax.
A third and very significant tax change for developers and investors is the proposed change to capital gain tax rates. Currently, long-term capital gains are taxed at preferential rates. The maximum rate is 20% compared to the top ordinary income rate of 37%. The Biden Tax Plan would leave this 20% rate in effect, but only on incomes up to $1,000,000. Once an individual has income in excess of this proposed cap, capital gains would be taxed as ordinary income – Biden’s new proposed 39.6% rate. This change could have a huge impact on how a seller might structure a sale, in turn affecting the net cash proceeds remaining for further reinvestment. If such a policy is implemented, for those with anticipated significant gains on real estate sales, it may be worthwhile to pursue other avenues to spread this gain across multiple tax periods such as through installment sales, or deferral of taxes through like kind exchanges (more on that later), or investment of those gains in qualified opportunity zones.
Qualified Business Income Deduction
The Qualified Business Income Deduction (also known as the 199A deduction) was introduced by the TCJA for the 2018 tax year. Most pass-through business and rental incomes from real estate development and investment fall under the definition of qualified business income, which provides a taxpayer with up to a 20% deduction against this income, subject to several limitations. In a simple example, a taxpayer with $1,000,000 of adjusted gross income that is all qualified business income would receive up to a 20% ($200,000) reduction in that income. This is a very significant benefit, especially when considering top tax rates of 37%, or the proposed 39.6%.
The Biden Tax Plan proposes phasing this deduction out entirely for those with incomes in excess of $400,000 – a significant loss for many developers and investors. If this proposal is signed into law, one may expect that many developers should reexamine entity selection to determine what form of business (S-Corp, C-Corp, or Partnership/LLC) would be most advantageous. This is especially true when paired with the proposed changes to self-employment and payroll tax rates.
First Time Homebuyers’ Tax Credit
The Biden Tax Plan would bring back a tax credit, which was originally put into place during the Great Recession, by providing a $15,000 tax credit to first-time home buyers. This is not a credit that would be available directly to investors and developers, but for those who deal in single family and small multi-family residences, this proposed tax credit has the potential to increase demand, and therefore prices, of new construction and/or smaller investment properties. For inventory already in hand, this could increase selling opportunities, while for those looking to purchase additional properties, it will mean additional competition with buyers seeking a primary residence. A developer or investor who deals in residential rental properties could see such a tax credit lure more taxpayers out of the renters market and into the home buyer market – potentially reducing the competition that has increased rents and values of multifamily properties over the last several years.
In order to address the shortage of affordable housing in many parts of the United States, the Biden Tax Plan would introduce a renter’s tax credit that would help reduce the effective rent and utilities of eligible taxpayers as defined under the Section 8 housing programs to a maximum of 30% of their income. This credit could be of significant benefit to investors and developers in the residential rental market, by enabling receipt of more consistent rent payments or allowing rents to increase to market rates. A significant concern for the developer or investor could be the regulations that a landlord would need to follow – for example, if you have tenants utilizing such credits, would rent controls be in place? Biden’s Tax Plan includes discussion of programs that would create additional barriers to evicting problem tenants.
Investment Incentive Programs
The Biden Tax Plan proposes an expansion to the Low Income Housing Tax Credit, a longstanding program that has provided investors with tax credits in exchange for acquisition, rehab, or new construction rental housing that targets lower income households. While the Biden Tax Plan is not explicit on what the expansion will entail, the credit is promised to be made more “efficient” – allowing more access to its use in order to increase incentive to produce additional affordable housing. Historically, these credits have been used primarily by institutional investors, but perhaps the changes to the program will allow for more ready access by non-institutional developers looking to invest in lower income areas.
Another somewhat little-known tax credit that Biden proposes to expand is the New Market Tax Credit, which provides tax credits as an incentive to encourage investment in low income communities. If a project is approved by the US Department of the Treasury, the investors will receive up to a 39% tax credit (spread over 7 years) based on the cost of the project. Historically, the New Market Tax Credit program has been funded in the range of $1.4b – $1.9m annually, with most of the credits claimed by large corporate entities. The proposed expansion would fund the program with an additional $5b annually – a substantial growth that may open up opportunities for a number of developers and investors to utilize these programs for eligible projects.
The Biden Plan also proposes additional funding and changes to the Community Development Block Grant program, which has the goal of expanding infrastructure and availability of affordable housing in specified markets – including for construction, rehabilitation, and acquisition. How these funds may be available to investors and developers remains to be seen.
Like Kind Exchanges
President-Elect Biden proposes eliminating the ability for wealthy taxpayers (assumedly, those with incomes over $400,000) to utilize the tax tool known as the Like Kind Exchange, or 1031 transaction. A 1031 transaction allows a taxpayer to defer payment of tax on the gain from sale of a property by ‘exchanging’ it directly for another – most commonly through a qualified intermediary. The basis in the original property is carried over to the exchanged property in order to preserve the gain, but no gain is recognized until the final property is actually sold. This tool has been used by real estate investors for decades as it allows them to liquidate a property, but maintain control of 100% of their proceeds rather than paying tax, resulting in a greater down payment in their next property.
The Biden Tax Plan and other proposals appear primed to have a significant impact on the world of real estate investment, including the tax rates that will be paid, tax deferrals opportunities, and investment incentive programs. If passed, each developer and investor will need to look closely at how the changes might impact their business structure, strategy, or the potential to pursue new investment programs.
For more information or a discussion on how this may impact you, please contact Kory Reynolds or your BNN advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.