Applied Research Initiative Bergstrom Real Estate Center

Death, Taxes & Real Estate

Since the beginning of the year, approximately $6 billion in new spending has been approved or proposed in the Covid Relief Bill, American Families Plan (AFP), and American Jobs Plan (AJP) . The corollary to incremental spending is incremental funding through tax proposals. Several new taxes have been proposed in the AFP and AJP.

While reading one of the many articles about the pending tax change proposals, one phrase caught my eye. A proposed change is to “eliminate real estate industry tax loopholes.” The fact that code containing real estate rules was described as having “loopholes” while other changes were described as “credits” and “benefits” led me to believe that the author viewed the current real estate tax rules as unjust. In an effort to separate from the emotion inherent in tax plans and avoid the political posturing, this short note will identify some of the proposed tax changes and offer an opinion as to how these changes might impact the real estate industry.

Before listing the proposed changes, we should be clear that our analysis will describe the marginal impact of the changing tax. Specifically, we will not attempt to measure the absolute amount of tax collected before or after the change nor the market impact of existing  or proposed tax plans. We offer an opinion about the incremental impact on the real estate market as the tax plan shifts from current to proposed. Furthermore, no attempt will be made to justify the current or proposed plans – this depends on an individual’s beliefs.

Some of the proposed tax changes in the AJP and the AFP are:

Affordable Housing  –

 Over $200 billion has been proposed in the form of tax credits, direct grants, and rental assistance to improve existing and develop new affordable housing units. The current Low-Income Housing Tax Credit (LIHTC) would be revised and a Middle-Income Housing Tax Credit (MIHTC) would be introduced. The Neighborhood Homes Investment Act would offer tax credits toward the development and renovation of qualifying properties. The plan also addresses exclusionary zoning and investment in public housing.

Impact Opinion –

An expansion of tax credits to housing development will draw private capital to qualifying projects. This should increase the level of construction and encourage renovation. It will also divert some capital from marginal market-rate projects to credit-qualifying projects. Overall construction should increase as the market shifts from mid-rent construction to lower-rent construction. Luxury construction should not be impacted and continue to be driven by market conditions.


Capital Gains Rate –

For households making more than $1 million in income, the maximum capital gains rate will jump from 20% to 39.6%, the proposed Ordinary Income Rate under the proposed plan. If we learn that this rate does not include the 3.8% Medicare surcharge on investment income, then the marginal rate will top at 43.4%.

Cropped shot of a businesswoman using a calculator at her desk in a modern officeImpact Opinion –

For private real estate investors, this is possibly the most impactful proposed change to the tax plan. For the specified group of investors, there will be no incentive to make long-term investments. These investors, to the extent they continue investing in property, will be encouraged to extract capital as soon as possible and minimize reinvestment in existing assets. Asset quality will fall.

There are short-term and long-term impacts on the real estate markets from an incremental increase in the capital gains rate; particularly a change of this magnitude. Short-term, investors should attempt to take gains prior to the effective date on all currently held long-term investments. By doing so, they will incur a 20% tax on gains and could return 80% of the prior value into new property at a current basis. Failing to do so will result in a doubling of the tax on currently unrealized gains. This should lead to a flurry of activity followed by reduced liquidity and a lower market value of real estate.

The long-term effects depend on the market influence of the investors affected by the change. Either this group constitutes a meaningful percentage of the market for investment real estate or it is a small group that will not impact market. If the group is large, then liquidity will diminish and values will fall to offset a portion of the reduced after-tax cash flow. There will also be upward pressure on rents following a period of supply adjustment. If the group is small, these investors will be driven from the real estate investment market or forced to accept lower returns. The real estate market will lose demand from the loss of some participants and will become marginally more institutional.


Corporate Tax Rate –

The proposed change in the corporate tax rate is a partial reversal of the change established in the 2017 Tax Cuts and Jobs Act (TCJA) that reduced the maximum rate from 35% to the current 21%. The AJP raises the corporate income rate from 21% to 28% and adds a minimum book tax of 15%.

Impact Opinion –

The simple impact of raising corporate tax is to lower distributable income which leads to reduced stock value. Of course, the stock market equation is a complex and uncertain one and the tax burden will be shared among investors, suppliers, customers, and employees. These effects will adjust over some period of time making it very difficult to measure the exact impact. It is clear that extracting higher incremental tax will force many groups to pay the price.

All things being equal, the specific act of raising the corporate rate will make REITs relatively more attractive. If REITs can continue to shelter Pass-Through Income, then the value of the REIT tax advantage will increase as REIT income will remain the same and corporate income will be reduced by the increased tax. The higher corporate rate is an increased burden on regular corporations beyond the tax that they are paying today. Before you rush out to pick-up some REITs, be aware that there are proposals to eliminate the pass-through treatment which will put REITs on par with corporations. This would make REITs less attractive relative to corporations than they are today. To date these pass-through elimination proposals have not been formally released.


Gains Tax Upon Death  –

Without attempting to describe the complexity of estate taxation, generally real assets transfer from decedent to heir without a gains tax and at a stepped-up basis under the current code. The proposal is for death to trigger a taxable event on property gains (proposed to be at the Ordinary Income Rate). With the exclusion of continually operated businesses and farms, property transferred from decedent to heir will carry a gains tax on all appreciation from the time of decedent’s purchase. Heirs will effectively “purchase” the current basis as opposed to inheriting it.

Impact Opinion –

The effect of the new plan is equivalent to selling all property upon one’s death, paying tax on the gains (at 39.6% / 43.4%), and repurchasing the property at current market prices. This applies to stocks, bonds, real estate, and other capital assets and is triggered at $1 million income. On the margin, individuals are again disincentivized to hold long-term assets or to include them in their estate planning. This change is likely to have much less impact than the capital gains change but the incremental effects are similar. Removing the step-up will reduce demand for capital assets and increase the relative value of cash. This will shift wealth from investment to savings which will marginally lower productivity.


1031 Exchanges –

Under certain conditions, 1031 Exchanges allow real property investors to transfer taxable gains from a sold asset to a newly purchased asset as a non-taxable event. This does not reduce tax owed but defers the taxable event to the future. For a more complete description of 1031 Exchanges, please see our March 2021 issue of Due Diligence. The proposal is to eliminate these exchanges requiring tax on gains to be paid upon every sale.

Impact Opinion –

Exchanges are complex and specific but they are intended to encourage investors to return capital from one real estate asset to another. Further, gains earned on the original property are kept in the real estate market compounding the investment rather than routinely extracting gains. The percentage of transactions executed as exchanges is too low to suggest that removal of their benefits will materially alter property values. However, on the margin elimination of exchanges will reduce the demand for investment property.

Given the trade-off nature of exchanges, as described in the afore mentioned article, the market will lose some capital from some participants and the incremental tax revenue will be limited. This change will affect some investors materially but go unnoticed by many investors. There may be a wave of transaction activity surrounding the effective tax change date and the market will quickly adjust to a similar equilibrium .


USA flag and American dollars. American flag blowing in the  wind and 100 dollars banknotes in the background.

Other Proposed Changes –

There are several other proposed tax changes that may impact the real estate markets. These include, but are not limited to, raising the maximum individual rate from 37% to 39.6%, reinstating the social security payroll tax of 12.4% on income over $400,000, doubling the Global Intangible Low-Taxed Income Rate, and limiting itemized deductions. These changes may not have direct impact on real estate but there may be derivative effects.

 


 Conclusion –

This has not been an exhaustive list of all proposed tax changes nor has it been a technical description of the specific code. Hopefully, this cursory run through the pending proposals has offered some thoughts for further consideration. Regardless of one’s perspective on these proposals it is clear to everyone that rather dramatic taxation changes are pending. For better or worse, markets and individuals will be adjusting to these proposals for several years.

According to proponents, these proposed tax changes have very little direct effect on taxpayers with income below $400,000. However, we would be naive to believe that such significant changes to the tax code will not filter through all markets and all individuals. There is at least one major assumption required to believe that these changes will not have a significant wealth effect on all taxpayers. We must assume that real estate market participants will continue the same activity and simply absorb the income reduction of these programs. A more plausible scenario is that property values will fall, owners will reduce operating costs and pass incremental tax costs to users until the investment returns resemble the current required rates. The market will find a new balance. It is your personal belief system that determines if this new market balance is better or worse than the current balance.