[Editor’s Note: Today’s article is a guest post from a friend of mine that wants to remain anonymous. He’s a doctor that teaches other doctors about all types of money matters at Wealthy Doc. ]
As a real estate investor, the Wealthy Doc understands that one of the MOST important benefits for investing in the first place has to do with taxes.
He, like most other real estate investors, have concerns about some of the possible changes the government is currently discussing regarding real estate tax loopholes.
These changes are highlighted below. As he shares his insights, I’ll chime in from time to time with my thoughts…
Take it away….. Wealthy Doc!
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There are numerous benefits to invest in rental properties.
I’ve written about those benefits elsewhere and even created a catchy acronym, CANDY.
Many of those benefits will continue into the foreseeable future.
Real estate investments should be part of all investors’ portfolio.
The “Evil Rich” 
President Biden’s proposed tax changes threaten real estate’s tax benefits.
His stated goals are to make the “rich” pay “their fair share.”
He intends to close “loopholes” that allow the “rich” to avoid paying their “fair share” of taxes.
This raises many issues such as why “rich” are defined by current income rather than net worth.
Related article: Wealth vs Income – What’s The Difference?
And why the affluent who already pay the majority of all taxes are paying an “unfair” amount.
I’ll leave those for others to debate.
Proposed Tax Changes
I’m writing this as of 5/2/2021 and the changes have not yet become law. They may (I hope) get modified before taking effect in October 2021.
Lobbyists, Republicans, and moderate-conservative Democrats may make this proposal less damaging.
Current Tax Benefits
Let’s recap some of the current tax-advantages to investing in real estate.
Let’s say I invest with others (syndication) and buy a large apartment building. Any income I receive will be “better” than W-2 income from my day job. It won’t have the “social tax “burdens of Medicare and Social Security.
Dr. Jeff’s comments: Remember, the current tax rate (2021) for social security is 6.2% for the employer and 6.2% for the employee, or 12.4% total. The current rate for Medicare is 1.45% for the employer and 1.45% for the employee, or 2.9% total. If you’re self employed then you’d be responsible to pay the 12.4% social security and 2.9% Medicare taxes.
We can claim “passive losses” against such income from depreciation.
Depreciation deductions is a non-cash decrease in value of the asset.
I still receive income but the “depreciation expense” is subtracted from passive income. “Accelerated” or bonus depreciation can magnify and front-load this tax benefit further.
When the property sells at a higher value in the future that difference is “capital gain.” That is taxed at a lower rate (capital gains taxes = 20%) than my marginal tax rate on “ordinary income.”
2021 Capital Gains Tax Brackets
| Capital Gains Tax Rate | Taxable Income (Single) | Taxable Income (Married Filing Jointly) |
|---|---|---|
| 0% | Up to $40,400 | Up to $80,800 |
| 15% | $40,401 to $445,850 | $80,801 to $501,600 |
| 20% | Over $445,850 | Over $501,600 |
Image source – IRS.gov
I could avoid paying that smaller tax by buying a larger piece of investment real estate. If I use my profit as a down payment on a larger property I can avoid paying taxes in the process.
This is achieved through a “1031 exchange” also known as a “like-kind” exchange.
I can continue exchanging for decades into the future as my properties continue to grow. If I leave it to my heirs, they inherit it without paying tax.
This is because the property is assessed on a “step-up” basis. The value of the property would be set at the time of inheritance. It would not be based on the original buy price of the prior owner.
You may not care much about any of this. That’s understandable, especially if your taxable income is below $400K. Some changes take effect only for those making more than a million a year. So who cares, right?
I will sidestep the ethics of a Robinhood approach. As well as the economic effects of further progressive taxation to others.
Many medical specialists earn more than $400K and are therefore considered “wealthy individuals.” Never mind they may have huge student loans and a negative net worth.
If the tax proposal is implemented there will be several market-distorting effects. Granted this is based on my speculation of the future and my crystal ball is cloudy.
My advice to you would be to follow the legislation and be aware of the potential impact on future investment income.
Long-Term Capital Gain
The current proposal would double the tax for those affected.
Capital gain taxes would go from 20% to 39.6% as ordinary income at the highest marginal tax bracket. Adding a state income tax may bring the tax burden to over 50%.
What will be the effect? I’m expecting owners will be reluctant to sell and incur such a bill. If the commercial property is stable and cash-flowing especially for the next future years then there would be a disincentive to sell.
That will reduce housing inventory and reduce transactions.
Refinancing to put “lazy equity” to work without a taxable event would also increase and further reducing available inventory.
1031 Exchange
Biden originally hoped to eliminate this option completely. In its current version, “like-kind” exchanges will be allowed only up to $500k. An elderly person (say in CA) who bought decades ago would not be able to exchange into a larger property.
Holding longer will reduce inventory and increase housing costs. Qualified intermediaries will find their business vanishing.
This affects syndicates that use 1031 exchanges to reduce investors’ tax bills. This reduces the benefit of buying larger properties. Institutional buyers will want smaller properties such as condos and single family residential rental property. That way they can plan their exchanges and stay under the limit.
The big losers will not be the big players. The majority of the transactions are relatively small residential real estate. More buyers in smaller properties drive prices upward.
Expect more competition against smaller real estate professionals. This market distortion would shift interest from large deals to smaller deals. And maybe more buyers to newer construction Class A properties that can be held longer.
Carried Interest
Reducing or eliminating 1031 exchanges also harms “carried interest.” Any real estate developer and syndication sponsors/GPs need profit incentives. Creating a syndication requires hundreds of hours of work.
In addition to strong industry ties, strategic planning, and personal financial risk.
Deal sponsors are rewarded with profits at time of sale. This is sometimes called their “carried interest.” Smaller retail properties are often $1M – $5M and would be affected by the $500K cap. This could have a chilling effect of reducing experienced sponsors and their capital.
Those who do continue to make deals will need to make other changes to offset this tax loss. Those changes will increase expenses and decrease returns for investors.
Reduced profits mean less entrepreneurial activity.
Also, expect:
- loss of taxes
- fewer transactions
- resulting job losses
Step Up Basis
Knowing their heirs will escape taxation encourages real estate investment. Such investment encourages housing development, new construction, and real estate improvements.
All this would be diminished if the “step up basis” goes away. Heirs would inherit a large tax bill thus reducing the value of the property. This change would not harm the richest investors. The step up basis is most beneficial to middle class investors who are below the limits of estate taxes.
This change doesn’t harm the intended targets.
Possible market-distorting effects
These changes would put in place incentives for a frenzy of selling (and some buying) before the end of 2021. After which there would be a “frozen” real estate market.
Housing inventories may decline as prices rise. Smaller investors will see less benefit to building real estate portfolios. Investors may shift to other investments.
Increased demand in the stock market could result. This will increase speculation and transaction costs benefiting Wall Street. Large institutions will use their capital, CPAs, and tax attorneys to overcome obstacles. The rest of us will have no such luck.
The good news is that I’m still bullish on commercial real estate investing. But the proposed Biden tax changes would have some damaging effects on the real estate industry.
Stay tuned for many real estate tax laws to continue to change until voted on in October 2021.
Helpful Sources:
- Globest.Com
- YouTube Meet Kevin