Rod Kleif Real estate investor, mentor, coach, host, lifelong cash flow through real estate podcast.
As multi-family investment coaches and mentors, we often rashly quote the tax benefits of investing in a multi-family asset, and there are many. However, a number of proposed tax changes under the new presidential administration could reduce or eliminate some of these benefits. For this reason, it is important that investors publicize the proposal and start formulating a game plan should it eventually be translated into law.
Note: To be clear, this article does not provide tax advice. The changes discussed are still in the proposal phase and there is great uncertainty as to whether they will ultimately become law.
To understand how the proposed tax changes could affect apartment building profitability, it is first important to understand the tax benefits under applicable IRS rules.
What are the current multi-family tax benefits?
A multi-family facility has two major tax advantages. One has to do with the long-term capital gains tax rate, the other with a type of transaction known as a 1031 stock market.
The difference between the price paid for an apartment building and the price at which it is ultimately sold is called the “profit” and is taxable. If the property is held for less than a year, the taxes paid on the profit will depend on the individual’s tax bracket, which, according to the regulations in force, is between 10% and 37%. However, if the property is held for more than 12 months (most are) the profit will be taxed at a lower rate which can range from 0% to 20% depending on the person’s tax bracket. Individuals whose tax bracket is higher than the 20% long-term capital gains tax rate have the potential for significant tax savings.
Second, investors have the option to defer capital gains taxes by reinvesting their sales proceeds in another property that is considered “like”. This type of transaction is known as a 1031 exchange and there is no limit to the number of transactions. In theory, with a number of 1031 consecutive exchanges, an investor could defer capital gains tax indefinitely. As a result, your capital grows tax-free over time, which is also a great advantage.
In a proposal made earlier this year, President Biden’s administration outlined plans to drastically reduce these benefits in order to fund the government’s economic agenda. There are two important points.
Proposed changes to 1031 exchanges
As part of the plan, the Biden administration intends to make two important changes to the 1031 exchange program.
First, the government is trying to limit the dollar amount of profits that can be deferred on a 1031 exchange. There is currently no limit. Under the proposal, winnings in excess of $ 500,000 for single parents ($ 1 million for co-valid couples) could not be deferred. While this may not have an impact for many retail investors, it is likely to have a significant impact for medium and institutional investors.
Second, another great benefit of a 1031 exchange is that an investor’s heirs can inherit the property in a “tiered” way, which is its market value at the time of death. This has the net effect that the property can be passed on to the beneficiaries tax-free. The Biden government’s plan aims to abolish this benefit on properties with profits of $ 1 million or more for single taxpayers ($ 2.5 million for couples filing together) and requires that the heirs be Pay taxes on outstanding winnings at the time of death. On large properties with significant profits, the tax burden could be substantial.
The impact of these proposals is difficult to quantify. However, a 2021 analysis (download required) by Ernst & Young shows that the broader impact of these changes could be significant. With the current rules for exchanges of a similar nature, the company estimates the following for 2021:
• “In 2021, companies using the peer-to-peer rules would have 260,000 workers earning US $ 11 billion in wages and benefits directly supported by the peer-to-peer rules.”
• “Similar exchange rules would generate direct added value of $ 22.4 billion in the United States in 2021.”
In addition, the company states: “The introduction of a tax on ongoing investments would discourage and slow down the pace of investment, leading to market illiquidity and increased capital costs, affecting assets and rents.”
Based on this research, it is clear that the effects of these rules would go well beyond reducing the profitability of an apartment building alone. They could adversely affect commercial real estate investments in general.
Long-term capital gains taxes
The second important component of the proposal is to increase the maximum long-term capital gains tax rate for households with incomes of $ 1 million or more from 20% to 39.6%. The implications of such a change are clear; The tax burden on sales could almost double, discouraging investment and extending the holding period due to reluctant sellers.
What should investors do to prepare for change?
To be clear, these are suggestions only and are likely to meet stiff opposition from the commercial real estate industry and from Congressmen who would oppose such a change. However, that shouldn’t deter potential multi-family investors from preparing should they eventually become law. I offer two tips:
Prepare yourself first. Understand the specifics of the changes, understand the potential impact, and plan how investment strategies can change. Those who are best prepared for these new rules can benefit from new opportunities.
Second, look for alternatives. While the proposals specifically target 1031 exchanges, they do not (currently) appear to target other popular tax deferral programs like Delaware Statutory Trusts or Opportunity Zones. Investors should familiarize themselves with these programs and be prepared to act accordingly if the tax changes are incorporated into law.
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