In his first address to Congress, on April 28, 2021, President Joe Biden presented his American Families Plan, a new stimulus proposal that includes enhanced tax credits for families.
To fund the plan, President Biden called for increasing tax rates on capital gains and ordinary income for top earners. Currently, the top rate on ordinary income is 37% and the top rate on long-term capital gains is 20% (23.8% after factoring in the Net Investment Income [NII] Tax Surcharge). The higher rates proposed by the president would raise the top rate on ordinary income to 39.6% and increase the top rate on capital gains to the same 39.6% (43.4% after factoring in the NII Surcharge). In effect, capital gains will be taxed at ordinary income tax rates, to the extent that the taxpayer’s income exceeds $1 million for married filing jointly (MFJ) and $500,000 for single filers. These rates do not include state and local income taxes, which for residents in high tax jurisdictions like New York or California could reach a blended federal and state tax rate of more than 50%.
While these new tax rates would be levied on taxpayers earning more than $1 million ($500,000 single filers), the president has also proposed curtailing the taxpayer-friendly – and real estate-investing favorite – “like-kind exchange” under Section 1031. This provision allows for the deferment of capital gains tax when a business real property is sold and exchanged for property of a like-kind. Under Biden’s proposal, any gain on the sale of real property in excess of $500,000 ($1 million if MFJ) would no longer qualify for deferral under Section 1031. Removal of the ability to defer capital gains tax on the exchange of like-kind business real property would affect all taxpayers, regardless of their earnings, if the gain involved exceeded $500,000 ($1 million if MFJ). The Biden proposal would leave intact the Section 1031 deferment of gains up to $500,000 ($1 million if MFJ); it affects only marginal amounts above that benchmark. But it would still have a significant impact on many investors.
In the administration’s fiscal year 2022 revenue proposal, the administration has indicated that the proposal to increase the capital gains tax would be effective, on a retroactive basis, for gains recognized after April 28, 2021. However, the proposal to curtail like-kind exchanges, as well as the increase in the top tax rate for ordinary income, would be effective after December 31, 2021. This means that for tax year 2021, capital gains in excess of $1 million MFJ ($500,000 single filer) will be taxed at 37% (40.8% after factoring in NII Tax Surcharge) in line with the 2021 top ordinary income tax rate. Beginning with tax year 2022, that same capital gain will be taxed at the then prevailing top ordinary income tax rate of 39.6% (43.4% including NII Tax Surcharge).
To better understand these potential tax increases, let us take the following scenario as an example. In year 2022, a single filer taxpayer with no other income sells real property resulting in a $2 million long-term gain. Under the current tax regime, the taxpayer can recognize the income and pay $476,000 (23.8%) in capital gains tax. Alternatively, the taxpayer could elect to repurpose the funds received from the sale and purchase like-kind property, allowing the taxpayer to defer those gains. Under the president’s proposal, this taxpayer would lose the ability to defer gain from the sale in excess of $500,000 and would be subject to a tax bill of $553,000 ($500,000 net capital gain deferred, $500,000 taxed at 23.8%, and $1 million taxed at 43.4%); previously the taxpayer would have faced a zero tax bill.
What is an investor to do?
While real estate investors may feel “boxed-in” under these proposals, a real estate-friendly tax provision enacted by the Tax Cuts & Jobs Act of 2017 appears to serve as an attractive option. Investing capital gain money into an Opportunity Zone (OZ) allows the original capital gain to be deferred and partially avoided. Appreciation in an OZ investment held for at least 10 years escapes taxation entirely when it is realized. This last point is especially important since a like-kind exchange can only defer, but not eliminate, gain.
OZ investments can be in the form of real estate or in an operating business located in an OZ. Opportunity zones have been specifically designated for this purpose. The program is designed to encourage those with capital gains to invest in low-income and undercapitalized communities. The OZ tax incentives are as follows:
- The ability to defer the recognition of capital gains invested in a “Qualified Opportunity Fund” (QOF) until the QOF investment is sold or December 31, 2026, whichever occurs first. This allows for greater investment opportunity in that the proceeds can be used for investment purposes immediately and the tax payment obligation is pushed forward for five years. A QOF is the vehicle through which an OZ investment is made.
- Investors who hold their QOF investment made in 2021 through December 31, 2026, only recognize 90% of this gain at that time.
- Investors who hold their investment for at least 10 years pay no tax on the appreciation of their QOF investment upon disposition of such QOF investment. In other words, a 2021 QOF investor defers the recognition of the 2021 capital gain until December 31, 2026, and pays tax on 90% of the gain at that time (at the then prevailing rate). If the investment is held for 10 years, the appreciation occurring during that time in the amount first invested in 2021 escapes federal taxation entirely. Compare this with the treatment accorded a like-kind exchange, which requires that the deferred gain be recognized when the property received in the like-kind exchange is ultimately sold.
- Note: These tax benefits are also available at the state level, for residents of states that conform to the federal treatment of OZ’s.
An important item to consider with OZ investing is that any capital gain, be it short- or long-term, sourced from any investment and not simply real estate, is eligible for investing in an OZ.
There are, however, certain downsides to this investment vehicle. The capital gain money is essentially “locked-up” for at least five years (through December 31, 2026), which entails an opportunity cost if the taxpayer could earn a greater return during this time elsewhere. While the tax on 90% of the capital gain is not due for five years, the taxpayer will need to provide for its payment from another source if it is not from the QOF. Additionally, OZ investing is restricted to specific locations designated for this purpose; an OZ investor cannot simply invest anywhere he or she wants. In fact, the Internal Revenue Service recently announced it will not expand any OZ boundaries that would be affected by the 2020 Census changes.
While permanent exclusion of the appreciation is appealing, to benefit there must be appreciation for that benefit to come into play. Not every opportunity will be a home run. An investment should make sense economically before the OZ benefits are considered. The OZ benefits can make a good deal great, but they cannot make a bad deal good.
Until now, the OZ program has not been embraced as completely as its proponents had wished. This may have been due to the pandemic, at least in part. Another factor, specifically for investors with real estate gains, was the availability of a like-kind exchange. Unlike an OZ investment, like-kind exchange gains can be rolled into real estate anywhere in the US, as opposed to the geographic restrictions inherent in an OZ investment. However, given the tax proposals included in President Biden’s congressional address real estate investors should consider investing in OZs even if they were reluctant to do so beforehand. If, indeed, like-kind exchanges are eliminated (at least for gains of more than $500,000), there will no other tax-advantaged mechanism for rolling a gain into another investment.
While OZ investments are not without their downsides, the other side of the coin is the ability to defer all capital gain for five years, as well as the potential for complete elimination of the 10-year appreciation, which becomes even more attractive when one considers the magnitude of the proposed increase in the capital gains tax rate. Using the example above, by deploying the $2 million capital gain realized from a sale of an investment (be it real estate or any other investment) into an OZ, the single filer taxpayer would be able to benefit from the following:
- Deferment of $770,000 ($1.5 million capital gain taxed at 43.4%, and $500,000 taxed at 23.8%) capital gain tax.
- Reducing the capital gain recognized in 2026 by 10%, or $200,000, thus saving $86,800.
- Savings of 43.4% on future capital gains recognized upon disposition of an OZ investment.
While OZ Investing has its strengths and weaknesses, the benefits would likely increase exponentially if the Biden proposals were ratified in some form. Opportunities historically available to investors rivaling the benefits offered by OZ investing will no longer be available, making investing in OZs the primary vehicle to help defer and reduce a taxpayer’s tax liability.
Disclaimer: While President Biden has proposed various tax increases, the final bill, if it were to pass, may be quite different than what was included in the President’s speech to Congress. The purpose of this article is to bring awareness to the readers of potential tax policy changes that can significantly impact financial investing, with specific attention devoted to the real estate industry.
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