On April 28th the White House released the American Families Plan, a massive economic stimulus and social spending proposal. It calls for trillions of dollars in spending for infrastructure improvements and a wide range of social programs that would be funded, in large part, by tax increases that would directly impact the commercial real estate market. Of greatest concern to us is the plan’s call to tax capital gains as ordinary income, severely limit 1031 exchanges and tax capital gains at death, effectively eliminating the step-up rule, a widely-used estate planning strategy for investors large and small across the country. In this post we take a look at the impact of taxing capital gains at ordinary income tax rates.
Currently, capital gains at the federal level are taxed at a 20% rate, plus another 3.8% Net Investment Income tax levy to help fund Obamacare. Depreciation is recaptured at a 25% rate, so the actual federal tax rate on capital gains varies slightly depending on how long a property was held before a sale. California already taxes capital gains at ordinary income tax rates, which run as high as 13.3%. We have found that a good rule of thumb is to assume that federal and state taxes will be roughly 35% to 36% of the total gain. Thus, a $2 million realized gain would carry a tax liability of up to $720,000, the prospect of which is enough to discourage most investors from selling their properties.
If the American Families Plan becomes the law of the land, capital gains would be taxed at ordinary income rates, which would top out at 39.6%. The 3.8% Net Investment Income tax would then be added, bringing the total federal tax obligation up to 43.4%, assuming that depreciation will also be recaptured at ordinary rates. Add California state tax at 13.3% and the total tax liability moves up to a maximum of 56.7% of the entire realized gain. So, that same $2 million gain would carry a tax burden of up to $1,134,000. Using these examples, the increase in tax is $414,000.
The impact of such a drastic increase in taxation could have far-reaching effects. Commercial real estate, already a relatively illiquid asset class, would see hold periods increase as property owners may be even less inclined to dispose of their assets. Greater illiquidity would increase the risk of owning real estate and potential buyers would add an additional risk premium in their underwriting, resulting in pricing pressure.
Deferring tax liability through the use of IRC 1031 Exchange rules would become even more popular than it is today if gains were taxed as ordinary income. However, the American Families Plan also calls for the elimination of 1031 protection for gains exceeding $500,000, a threshold that would be exceeded in the vast majority of commercial property exchange transactions. More on that in our next post.
While this massive tax increase is still in the discussion stage and no one knows the final outcome, it does pose a real threat to the commercial property market and is worthy of your attention. We recommend that you seek the advice of your trusted tax and legal advisors to determine how you would be affected if capital gains were taxed at ordinary income tax rates. If we can be of any assistance to you in your real estate planning, please give us a call.
