On April 28, 2021, President Biden announced the American Families Plan to propose funding for education, child care, and the extension of certain tax credits for lower- and middle-income individuals. The White House released a fact sheet describing these proposals, and President Biden discussed them in an address to a joint session of Congress. President Biden’s plan would fund these proposals through increased taxes and other significant tax law changes. These changes would be in addition to the tax law changes proposed in the American Jobs Plan announced by President Biden on March 31, 2021, which we covered here.
While it remains to be seen whether the proposals in the American Families Plan will be enacted into law, they may have significant effects on real estate investors and developers.
Proposed Revenue Raisers Potentially Affecting Real Estate Industry
Proposed revenue raisers in the American Families Plan of particular interest to real estate investors and developers include:
- Increasing the top federal income tax rate on ordinary income to 39.6% for high-earning individuals —it has been reported that this rate would apply to individual single taxpayers with taxable incomes greater than $452,700 and to married couples filing jointly with incomes greater than $509,300
- Increasing the top federal income tax rate on capital gains and dividends to 39.6% (plus 3.8% Medicare tax) for households with income greater than $1 million per year
- Closing “the carried interest loophole” so that “hedge fund” partners will pay ordinary income rates on their income “just like every other worker”
- Eliminating tax-deferred Section 1031 like-kind exchange treatment for capital gains greater than $500,000
- Closing the “stepped-up basis loophole” that occurs in property upon death for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions)
- Extending permanently current limitations restricting deduction of “excess business losses”
- Expanding the 3.8% tax on unearned income (sometimes referred to as Medicare tax) to unspecified categories of income currently not covered
- Requiring “financial institutions to report information on account flows so that earnings from investments and business activity are subject to reporting more like wages already are”
The plan also calls for increased IRS enforcement discussed in more detail here.
These proposed changes would presumably be combined with the American Jobs Plan’s proposed increase in the top federal income tax rate on C corporations to 28%, discussed here.
Elimination of Lower Tax Rates Applicable to Long-Term Capital Gains of High-Income Individuals
The American Families Plan proposes to increase the top federal income tax rate on long-term capital gains from real estate and all other investments from 20% (plus 3.8% Medicare tax) to 39.6% (plus 3.8% Medicare tax) for households with income greater than $1 million per year. While the proposal would also similarly increase the tax rate applicable to qualified dividend income, nothing is included in the proposal (at least at this point) that would eliminate the 20% Section 199A deduction applicable to REIT dividends.
The American Families Plan proposes to “close the carried interest loophole” so that “hedge fund” partners will pay ordinary income rates on their income “just like every other worker.” This presumably refers to the ability of a service provider to pay tax at capital gain rates, rather than ordinary income rates, on disposition of a profits interest.
The scope of the proposal is uncertain. In particular, it is unclear whether the proposal would extend beyond “hedge fund” partners to partners of real estate partnerships (which are much different than hedge funds). It is also unclear whether the proposal would eliminate or curtail the other principal advantage of the treatment of carried interests - the deferral of tax resulting from carried interests not being taxed upon grant or vesting - or whether it would supplant the new holding period requirements imposed by the 2017 Tax Cuts and Jobs Act on certain carried interests.
Elimination of Section 1031 Like-Kind Exchange Treatment
For almost a hundred years, Section 1031 like-kind exchange treatment has been a valuable tool for allowing real estate investors to roll the proceeds of real estate sales into purchases of other real estate without paying capital gains tax on the profits. This deferral process can theoretically continue indefinitely, by the investor either continuing to hold the property or engaging in one or more subsequent like-kind exchanges, until the investor’s death. At that time, the heir’s tax basis in the real property can (under current law) be stepped up to fair market value without triggering any income tax.
The American Families Plan proposes to eliminate tax-deferred Section 1031 like-kind exchange treatment for capital gains greater than $500,000. The 2017 Tax Cuts and Jobs Act had previously eliminated tax-deferred Section 1031 like-kind exchange treatment for all property other than real property.
Closing the “Stepped-Up Basis Loophole” for Property Upon Death
As discussed in the preceding section, current law provides that, when a person who holds appreciated real estate or other appreciated assets dies, heirs who inherit those assets are permitted to step up the tax basis of the assets to their then fair market value. The American Families Plan proposes to “close this loophole, ending the practice of ‘stepping-up’ the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions [e.g., the primary residence exemption]) and making sure the gains are taxed if the property is not donated to charity.” It is unclear from the fact sheet whether this means that the step-up in basis for such gains would be eliminated or, alternatively, that such gains would be taxed upon death. A press release issued by the Department of Agriculture indicates that the proposal would subject the unrealized capital gains (those that have never been previously taxed) to income tax at death. Under the proposal, there would be protections “so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”
Enactment of this proposal, together with the simultaneous enactment of the proposals to almost double the top tax rate applicable to long-term capital gains and eliminate tax-deferral for like-kind exchanges, represents an extremely unwelcome triple threat to real estate investors.
Expanded Base for 3.8% Medicare Tax
The Administration is also encouraging Congress to close what it sees as loopholes in the 3.8% Medicare tax. The fact sheet asserts that this tax is “inconsistent across taxpayers due to holes in the law,” and the proposal would target those with income in excess of $400,000 per year. The details of this proposal have not been released, although it may include imposition of the 3.8% Medicare tax on certain types of business income that are not subject to self-employment tax (e.g., rental income of persons actively engaged and materially participating in real estate businesses).
Excess Business Losses
The American Families Plan would make permanent the current rule disallowing excess business losses of non-corporate taxpayers. This rule was enacted as part of the 2017 Tax Cuts and Jobs Act and generally disallows certain business losses (including losses allocated from real estate and other partnerships) in excess of specified thresholds. The provision is currently set to expire at the end of 2025, but the Administration is proposing to make it permanent.
Expanded Information Reporting Requirements
The Administration also previewed expanded information reporting requirements by financial institutions on “account flows.” The fact sheet cited a 2019 economics working paper broadly critical of a lack of cross-party reporting with respect to certain items of income, including rental income, but the text of the proposal refers only to expanded reporting for “financial institutions.” According to a press release issued by the Department of the Treasury, this proposal “leverages the information that financial institutions already know about account holders, simply requiring that they add to their regular, annual reports information about aggregate account outflows and inflows.”
We will continue to monitor developments and will provide further updates as more details are released. In the meantime, Baker Botts would be pleased to assist you in your analysis of these proposals.
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