A Look at the Challenger's Tax Proposals

A Look at the Challenger’s Tax Proposals

Those aspiring to high office have to balance the impression they make on those in their own party with how their proposed policies will be received by voters from the opposition party, as well as those who don’t necessarily vote along party lines. The current election cycle has been especially difficult, as our political landscape has become more polarized and hyperbolic, making it even more difficult to sift through the rhetoric to access the real policy differences between the candidates.

As a commercial property investor and property management firm, we are particularly concerned with how each presidential candidate’s proposed policies could affect the real estate market. So, in this post we share some of our thoughts on the tax policy platform of the challenger as published on his campaign’s website. It represents a significant change in direction that would, we believe, be detrimental to the commercial real estate market across the country if some or all of his proposals became the law of the land. Specifically, we address possible changes to Capital Gains tax rates, IRC 1031 Exchanges and the Step-up Rule. Let’s get started:

Eliminate Capital Gains Tax Rates

Currently, the federal capital gains tax rate is 20%, having risen from 15% when the Bush era tax cuts expired seven years ago. Mr. Biden proposes that capital gains be taxed as ordinary income at a maximum rate of 39.6% (if he can push through an increase from the current maximum marginal income tax rate of 37%). Add that to the existing 3.8% ACA tax on investment income and his plan would tax capital gains at 43.4% versus the 23.8% it is today. State taxes would be on top of that. Clearly, this would discourage the disposition of real estate assets, reducing the flow of capital and upsetting the demand/supply balance and property values in the process.

Eliminate 1031 Tax-Deferred Exchanges

In addition to raising capital gains rates, Mr. Biden proposes to eliminate tax-deferred exchanges pursuant to Internal Revenue Code 1031, a strategy used in up to 40% of all commercial real estate transactions in the US. This, on top of paying ordinary rates on capital gains, would further discourage real estate dispositions, negatively impacting property values across the board. The exchange strategy has helped countless investors build wealth through real estate ownership for decades and its elimination would be a huge shock to the property markets. Real estate is relatively illiquid, unlike stocks that can be sold with the touch of a button. But, the ability to defer gains while building wealth, which can’t be done with stocks, is one of the main reasons investors look past the liquidity risk to own real estate. Without that advantage, real estate, as an asset class, is likely to suffer.

Eliminate the Step-up Rule

Under current law, the heirs of a real estate portfolio receive it with a step-up in basis to the value of the property at the time of the benefactor’s death. This allows the heirs to immediately sell off assets with little or no tax consequences. This is why so many investors continue exchanging properties during their lifetime. It is colloquially referred to as a swap-‘til-you-drop strategy and it is wide use by investors large and small, and its sudden departure would have a massive impact on the supply/demand balance. Just the threat will probably be enough to send investors back to their estate planners for a thorough review of their exit strategies. Since so many properties are being held specifically to take advantage of the step-up rule, its elimination could cause a potential flood of supply and lower property values going forward.

Uncertainty Going Forward

Even if we do have a new President, the implementation of these proposals is no forgone conclusion, but in the event the Senate majority changes hands, they become a very real possibility. That alone has the power to change investor attitudes toward taking on the risk of owning and operating commercial real estate assets. The choice is ours to make and it should be one we all, regardless of our political affiliation, to take seriously.