Will the tax reform be a commercial real estate game-changer? With the change of guard in the United States government, now is the time to put the tax proposal in perspective and learn how the Deferred Sales Trust can help you prepare for the federal capital gains tax rate moving from 20% to 39.6%, elimination or reduction of the 1031 exchange, elimination of the stepped-up basis, carried interest to be considered ordinary income, and the $11.58M estate tax exemption decreasing to $3M.
5 PROPOSED TAX CODE CHANGES
1. Federal Capital Gains Tax Rate Increase by Almost Double
The American Families Plan proposal would double the long-term capital gains rate from the current 20% to 39.6%, not including the existing Net Investment Income tax of 3.8% and any state taxes payable.
2. Eliminate the Stepped-Up Basis for Inherited Property
The American Families Plan proposes major changes to the way estates treat capital gains. Currently, the value of assets in the estate, including investment property, is “stepped up” to fair market value at the real estate investor’s date of death. In that way, the inheritors do not have to pay capital gains tax on the capital appreciation of the decedent’s assets. If the Families Plan is passed, this step-up would be eliminated for gains in excess of $1 million ($2.5 million for couples when also considering the existing exemption for their primary residence). If the step-up in basis were eliminated, inheritors would have to pay capital gains whenever they sold the assets, including millions of dollars worth of investment properties or a family home. If the asset had been purchased for a low price many years ago and held, then the tax basis vs gain (the property’s current market value at the asset owner's death) would trigger a large tax, leaving much of a family's real estate wealth legacy to pass to the government. This will be a game-changer for many investment real estate owners who were underwriting their cash flow and wealth model based on, “swap (1031) until you drop and drop until you drop.” Inheritors may feel compelled to sell inherited property in potentially unfavorable market conditions just to pay the tax. This is kind of like letting the government tax bill wag the selling of the investment dog.
3. Sunsetting Estate Tax Exemption
The $11.58M estate tax exemption could decrease to $3M. The federal estate tax exemption is the amount you may give away during your lifetime and own at your death without subjecting it to a 40% estate tax. In other words, any assets you own at your death in excess of the current estate tax exemption will be subject to a 40% tax on its fair market value.
4. Carried Interest & Promotes To Be Treated as Ordinary Income
Many CRE investment projects are sponsored by a general partner who can earn a share of the profits associated with the investment based on certain performance hurdles. This share of the profit is known as the sponsor’s carried interest or “promote.” Currently, “promotes” in real estate partnerships are generally taxed at the long-term capital gains tax rate. The proposal would treat “promote” interests as ordinary income. As a result, the sponsors would receive fewer net profits and would have less incentive to invest in improving real properties or hitting performance hurdles.
5. Elimination or Reduction of the 1031 Exchange
The American Family Plan partially repeals the remainder of IRC Sec. 1031, limiting the amount of the gains deferral to $500,000, which practically eliminates the 1031 exchange for anyone selling property with a gain of $500,000. To clarify, you could still use the 1031 exchange for properties of any value, however, if the capital gain on the sale of property exceeds $500,000, the excess gains would be taxable at the new higher individual income tax rate.
What the Deferred Sales Trust Can Do for You
Consider selling assets before you die and moving them into the Deferred Sales Trust or Deferred Sales Trust Plus in order to:
- Defer higher capital gains tax.
- Move equity outside of your taxable estate to eliminate the 40% estate tax.
- Maintain deferral of capital gains tax, which your inheritors can continue to defer.
- Defer your carried interest to prevent it from being taxed at ordinary income rates.
- Eliminate the need for a 1031 exchange.
Sorting out capital gains tax deferral strategies can be confusing. Also, finding a tax deferral strategy with a proven track record that gives you debt freedom, liquidity, diversification, and the ability to move funds outside of your taxable estate, all without using a 1031 exchange at the same time, is difficult. That’s why we’ve started Capital Gains Tax Solutions and offer The Deferred Sales Trust™ (“DST”). So you or your clients never have to feel trapped by capital gains tax or a 1031 exchange ever again. Here’s to making the best decision for you, your family, and your estate, no matter what the final decision will be for the Biden administration on the 1031 exchange.
About the Author
Brett Swarts is the founder of Capital Gains Tax Solutions and host of the Capital Gains Tax Solutions podcast.