With the election season upon us it’s a good time to review some of the tax proposals that are being suggested. According to numerous online sources, Presidential nominee Joe Biden is proposing a number of changes to the Federal tax code that would affect commercial real estate investors.
The goal of this blog post is NOT to be political or share my personal opinion BUT instead to state the facts as I understand them so that those within our industry can make thoughtful and informed decisions. And, of course, I am not a tax advisor nor an attorney and you should definitely consult such professionals before making any real estate decisions.
Please note that I relied on sources that I believe to be reputable such as Kiplinger, articles written by tax attorneys, Bloomberg, and similar. The tax proposals would include:
- The elimination of the 1031 exchange. There may be some exceptions for gains that are less than $400,000 OR when taxpayer’s income is less than $400,000 in the year of the sale – this is a bit unclear.
- The elimination of the step-up in basis upon death and/or treat the date of the owner’s death as effectively a sale with the requisite tax consequences of that sale.
- An increase in the long term capital gains rate from 20% to 39.6% for those earning more than $1M in a tax year.
- The elimination of Carried Interest’s treatment as long term capital gains. Carried interest is effectively the amount that a real estate sponsor (i.e. developer/syndicator) earns when the property they sponsored sells. For example,
- If a sponsor syndicates a $10M investment that is sold for $15M five years later, and the sponsor’s share of the gain is 30%, then the sponsor will have a gain of $1.5M.
- If treated as a long-term gain at a 20% tax rate, the sponsor would pay $300K of taxes. At 39.6%, the sponsor would pay $594,000 in taxes.
- Although one should not expect pity for the sponsor only making about $900K vs. $1.2M, but reductions in incentives do have consequences.
Keep in mind the tax proposals outlined above may not get adopted or get adopted in various forms. For example, the 1031 exchange may be eliminated, but long term capital gains may stay at 20%, and carried interest may continue using a 20% tax rate. This will have very different implications from the 1031 exchange option remaining, long term capital gains increasing to 39.6% and carried interest being eliminated.
BUT, let’s just assume that Joe Biden becomes our next President and ALL of these changes get implemented effective January 1, 2022. What might be some of the ramifications of the proposed changes:
Lots of Short Term Activity: There would likely be a flurry of property sold and exchanged BEFORE such new regulations take effect which could create supply and demand imbalances. For example, there might be more sellers of older commercial properties that have challenges resulting in higher cap rates for these properties to attract investors, while there could be greater demand for single tenant net lease properties resulting in lower cap rates for these properties.
Followed By a Lull: Once tax reform takes effect, the markets would likely see a substantial decrease in activity since so many investors will have recently made their buy and sell decisions.
Brokers Might Start Hanging out at Hospitals: Okay, this may be extreme, but you get the idea. Since someone’s death will likely trigger the sale of some of an heirs portfolio to pay taxes, it would create more opportunity for brokers to list and sell property.
Single Tenant Cap Rates May Rise: In my opinion the value of single tenant properties are artificially inflated because these assets are frequently the only way for someone to defer taxes with a 1031 exchange while trying to create the simplicity of owning bonds or equities. If single tenant properties have to compete for capital with non-real estate investments, the days of sub-5 cap rates could easily be over especially if short and/or long term interest rates move higher.
Potentially More Sales After the Shock Wears Off: Many long term successful investors are holding their real estate primarily because they know they will save their heirs millions of dollars waiting until they die so their heirs can benefit from the step-up in basis. If this benefit does not exist, owners may be more likely to sell later in their career and pay the taxes. This will take risk and stress away from the owner as they will now have plenty of liquid assets for their retirement. This will also allow them to leave their heirs with a portfolio that is much easier for them to allocate. It is much easier to split $10M of stocks and bonds versus $10M of real estate.
Less Development and/or Falling Prices for Land or Redevelopment Properties: If the Developer/Sponsor is going to pay a higher marginal tax rate then they will need to show a higher return on the project in order to earn a comparable after tax reward. As a result, fewer projects may “pencil” and/or more projects will require a lower acquisition cost so they will pencil.
We are currently in a place of great uncertainty and business hates uncertainty. However, this is a time to be pro-active and review your commercial real estate portfolio, assess the probabilities of the proposed changes and talk to both your commercial real estate broker and tax/estate consultants so that you can make the best decisions relative to your commercial real estate holdings.
The Progressive Real Estate Partners team collectively has decades of commercial real estate experience and can help you better understand the challenges and opportunities. I invite you to reach out to myself or my team to discuss at 909-230-4500 or firstname.lastname@example.org.