Since the new administration has taken office this year, they have begun to implement a variety of proposed changes. Among the changes is the proposition of the American Families Plan.
The American Families Plan aims to support middle-class working Americans and children and families. One of the notable aspects of this proposed plan is its quoted cost. The plan, as it stands, will cost a predicted $1.8 trillion. When coupled with the recent COVID relief plans that have been implemented, many are concerned about where funding will come from.
The current proposed plans contain a variety of tax adjustments to support funding for this proposed plan. Overall, these tax adjustments aim to target wealthy taxpayers and investors. One of the proposed tax adjustments includes raising the top individual tax rate to 39.6 percent.
It should be noted that just recently in 2017 this very same tax rate was lowered by the previous administration from 39.6 to 37 percent. The new administration’s actions would serve to reverse this 2017 change implemented under the previous presidency.
Capital Gains Tax Adjustments
In addition to this change, the administration is also suggesting raising capital gains tax to 39.6 percent. This change is significant, nearly doubling the current rate.
In its simplest form, capital gains tax is charged on the value growth of investments accrued when individuals or corporations choose to sell those investments. It should be noted that selling assets that have been owned for less than one year are taxed at a higher rate than those held beyond one year.
The amount of capital gains tax that you are responsible for is based on the “realized gain”—determined once that asset sale has been made. Based on your tax bracket, current capital gains tax rates are either 0%, 15%, or 20%. As previously stated, the intention to raise this rate to 39.6 percent would be a near doubling of the highest current rate.
It should be noted that the rates previously mentioned do not include the addition of the existing 3.8 percent levy on net investment income that was introduced as part of the Affordable Care Act. Bringing this levy into consideration would bring capital gains tax up to a total of 43.4 percent if it were implemented as currently suggested.
What does this mean for the commercial real estate market?
Given these proposed updates, the question becomes what will come of the real estate market as a result. Real estate investors rely on capital gains to produce profits. Such significant increases in tax collection would be a dramatic deterrent for continued investment.
Section 1031 allowed profits from investment properties a tax deferral for like-kind exchanges as long as the investor uses profits for another investment property within 180 days. However, if this is revoked, it would directly impact the commercial real estate market and potential future investments.
The current presidential administration argues a tax implementation on investment property profits will, in turn, benefit workers and middle-class Americans. The goal of revoking section 1031 is expected to create $19.5 billion in tax revenue over the 10 years to help fund the American Families Plan.
If implemented, deferrals on gains would be capped at $500,000 for a single taxpayer and $1,000,000 for married taxpayers. Concerns rise for economic stagnation if commercial investors participating in like-kind exchanges, who account for 10-20 percent of commercial real estate transactions, do not sell properties because of taxes on gains.
Each of these services would feel the impact of the proposal.
- Insurance companies
- Title companies
- Inspection companies
- Real estate services
Karlin Conklin, principal and co-president of Investors Management Group explains that “Section 1031 also encourages the resume of buildings because investors often focus on adding value to older properties that need work … Without exchanges, there’s going to be less money dedicated to improving older real estate stock that is in need of a capital infusion.”
Under the new proposed capital gains tax, an investment property that brought $1,000,000 in profit would be taxed $400,000 straight away. This leaves less revenue to upgrade an investor’s next venture.
With properties being turned around at competitive prices across the country, these proposed changes come at a time in our economy that the real estate market is strong for both sellers and investors.
A study by Ernst & Young found, “Like-kind exchanges and related consumer spending could generate $7.8 billion in federal, state and local taxes in 2021… Section 1031 could support as many as 710,000 jobs that generate labor income of up to $34.4 billion this year.”
The current seller’s market has many homeowners eager to take advantage of the opportunity to sell properties at competitive prices. The threat of these tax increases changes this thought process, however, and forces market experts to question whether property owners will continue to turn around properties if they suspect losing such a significant portion of their realized value.
Mr. Brown, the past president of the National Association of Realtors explains in a New York Times article, “more and more minorities want to become real estate investors because they can see the benefit of building wealth and income. Getting rid of the 1031 exchange would hamper their ability to do that because most investors cannot afford to sell a property and then buy something else after paying taxes.”
While none of the current proposals is anything more than a proposition, for the time being, they identify very real concerns within the industry. While we wait to see what Congress’s response to the proposed adjustments will be, investors should consider how implementation would affect them directly.
Looking to invest in a commercial real estate property? Read our 5 tips real estate investors should know before purchasing a new property.