The American Families Plan & Its Impact on the Real Estate Industry

Authored by RSM US LLP |  April 30, 2021

Tax Rates Increases

President Biden’s proposed plan would increase the maximum long-term capital gains rates from 20% to 39.6%for taxpayers making over $1 million annually. There is currently still ambiguity as to what will be includible in the $1 million threshold (gross income, adjusted gross income, taxable income, etc.). When factoring in net investment income taxes of 3.8%, the President’s proposal would increase the maximum rate paid on capital gains to a total of 43.4%.

The American Families Plan also proposes an increase to the top marginal ordinary income rate for individuals from 37% to 39.6%. This represents a reversal of the reduction in tax rate under the 2017 Tax Cuts & Jobs Act.

Further Limitations on 1031 Like-Kind Exchanges

The President’s plan also takes aim at limiting a taxpayer’s ability to utilize section 1031 Like-Kind Exchanges to defer capital gains related to sales of real property. The plan would no longer provide taxpayers the ability to utilize section 1031 Like-Kind Exchanges if the gains realized are greater than $500,000.

Repealing section 1031 Like-Kind Exchanges coupled with the proposed increase in capital gains tax rates could send ripple effects through the real estate industry, slowing the market with investors incentivized to hold existing assets for longer timeframes in the hopes of future administrations lowering the capital gains rate.

Elimination of Capital Gain Treatment for Carried Interest

The use of carried interest by hedge fund and private equity managers often times affords them the ability to pay taxes on their share of income at preferable capital gains rates. While the Tax Cuts & Jobs Act extended the holding period required for carried interests to achieve long-term capital gain treatment from one to three years, President Biden is seeking to remove the eligibility of capital gains treatment on carried interest all together. Under the President’s plan, carried interest income allocations would be taxed as ordinary income as opposed to capital gains.

At first glance, it may appear that the proposed increase to capital gains rates effectively eliminates the benefit of the carried interest provisions. However, if President Biden were successful in eliminating the capital gains treatment on carried interests, the carried interest amounts would be subject to ordinary tax rates even if the proposed increase to capital gain rates does not become law or re-negotiated down to a lower percentage as part of the lawmaking process.

Real estate investors largely escaped the changes to the carried interest rules under the Tax Cuts & Jobs Act. Section 1231 gains, such as gains recognized from the sale of a rental property, were not subject to these rules. President Biden specifically called out the hedge fund industry when discussing these proposed changes to carried interests, but it is unclear at this time whether or not he intends to re-class carried interest allocations of Section 1231 gains to be ordinary income. Recent bills, such as The Carried Interest Fairness Act, have been introduced that would make section 1231 gains subject to the carried interest provisions so it does appear that this is on the table.

Death as a Recognition Event

The proposed plan would require taxation of all unrealized gains in excess of the $1 million (or $2.5 million per couple when combined with existing real estate exemptions) as of the date of death. This will no longer allow for assets with large unrealized gains to escape taxation when passed down to generations upon death via a tax-free stepped-up basis. It appears that there could be exceptions to this tax liability upon death if the property either is donated to charity or is related to a family-owned business/farm that the heirs will continue to run.

Excess Business Loss Limitation

As part of the Tax Cuts & Jobs Act, section 461(I) was created to suspend excess business losses of non-corporate taxpayers if the amount of the loss is in excess of $250,000 ($500,000 if filing a joint return). Section 461(l) limits a taxpayer’s ability to utilize losses of their business to offset other sources of income (wages, portfolio income, etc.).

Although the Tax Cuts & Jobs Act limitation on excess business losses was set to expire for tax years beginning after Dec. 31, 2025, the American Rescue Plan Act of 2021 signed by President Biden earlier this year extended the loss limitation provisions for one additional year through 2026. The American Families Plan would permanently extend the section 461(l) loss limitation provisions, thus permanently restricting the deductibility of excess active pass-through business losses.

Expansion of the 3.8% “Medicare Tax”

The American Families Plan proposal also makes broad references to expanding the scope of the current 3.8% “Medicare tax”. This “Medicare Tax” comes in two forms: 1) Self-Employment tax or 2) Net Investment Income tax. The plan discusses the tax being more consistently applied on income earned in excess of $400,000. Although details are not yet available as to what type of income the Biden administration is targeting with this proposal, this could open the door to active income earned from rental real estate activities or earned through S corporations being subject to Self-Employment Tax.

Takeaway

It is important to note that this is President Biden’s “wish list” and is not necessarily a list of what will ultimately become law. There is a lot of negotiation to be had before a bill is introduced or enacted. However, the proposal provides a glimpse into what the President has his sights set on for tax reform and many of these items will have a significant impact on the real estate industry. For this reason, taxpayers should begin to consider what these changes could mean to them and their business.