Potential tax reform and rising inflation may slow down the booming housing market. Assessing the proposed tax legislation and current market conditions will help you plan for what’s next.
Right now, trying to predict the impact of federal tax changes on the residential real estate market is a guessing game. Since no bills have been introduced yet, it’s hard to speculate on some of the effects without details. That said, by assessing the proposed tax legislation in The American Families Plan (AFP) plus current market conditions and possible inflation through the lens of historical market trends, we’ve come up with some solid predictions. Read on for their prognoses regarding various aspects of potential tax reforms.
Increase in Personal Income Taxes and Capital Gains for Higher-Net Worth Individuals
The Tax Cuts and Jobs Act (TCJA) of 2017 reduced the top income tax rate from 39.6% to 37%. Reversing this change (for the top 1%) is a central aspect of the Biden administration’s proposed tax changes, as is ensuring that capital gains are taxed at the same rate as wages (39.6%) for households making $1 million plus.
There was a real estate boom, and it could end with this type of tax change. Right now, the housing market is dominated by the wealthy. If we change the structure to tax the wealthy more, they will have less money to spend on real estate and won’t compete as much with middle class buyers. Investor profits could decrease, as could the rate of home value growth. Right now, there’s not enough supply however, when demand shuts down and if capital gains taxes increase, investors will find other places to put their money. On the pro side, this type of tax reform could level the playing field for the middle class.
Reversal of the SALT Deduction Limitation
At this point, the Biden administration has offered no indication that they plan to reverse the $10,000 state and local property and income tax (SALT) deduction cap, which punitively affects states with higher taxes (such as California, New Jersey, and New York). The SALT deduction cap did end up having an impact on sales activity of homes that were on the margin, such as those priced between $1 million and $1.5 million in the Bay Area, as those households saw a material impact on their tax bill and had relatively ‘limited’ income [for that area]. The same could be said for some markets in the Northeast, such as Connecticut. On the slim chance that the Biden Administration does reverse this deduction limitation, the migration from high to low tax states (such as Florida and Texas) might abate.
There’s bipartisan support for repealing the cap, set to expire after 2025. But Democrats are looking to address the issue in a filibuster-proof budget reconciliation bill this fall that’s expected to offset trillions of dollars in new spending with tax increases that won’t get GOP support. A compromise short of full repeal appears to be the direction Democrats are headed.
Elimination of Stepped-Up Basis for Gains from Estates
Currently, heirs may defer taxes on inherited home gains until they sell the property. They also secure a so-called “step up in basis,” which adjusts the home’s purchase price generally to the value on the date of death.
By comparison, the Biden Administration wants to treat home inheritances like a sale, making the heirs pay for gains that occurred before they received the property.
The proposal includes tax exemptions up to $1 million for single heirs and up to $2.5 million for couples. For example, let’s say someone inherits a $1.5 million family home purchased for $300,000. That person may owe capital gains tax on $200,000 of the $1.2 million profit.
This tax may be a burden for heirs who want to keep the family home but can’t afford the tax bill.
Tip: One popular tactic is gifting a home or vacation property to heirs while living with a so-called qualified personal residence trust. This trust removes the home’s value from an estate and allows the original owner to use the property for a specific number of years.
Another way to save on taxes is by increasing the home’s basis to reduce profit. Homeowners can do that by tacking on the cost of improvements, like a new roof or other property renovations. This method may prove difficult for an inherited property without immaculate records.
End of 1031 Like-Kind Exchanges
Like-kind exchanges, also referred to as 1031 exchanges, have been in the tax code since 1921 and have allowed for taxpayers to exchange property that is similar and defer the recognition of gain. The justification surrounding the deferral of gain is that a taxpayer who enters into the exchange is merely changing their investment vehicle. Based on the mechanics of the provision, the taxpayer’s gain that would have been recognized had they sold the property outright is embedded in the property received. In other words, the asset appreciation on the exchange is not eliminated, but merely deferred until a later point in time when the taxpayer eventually sells the property received in the exchange.
The definition of like-kind real property is extremely liberal under 1031. For example, an exchange of commercial real estate for a ranch or farm is considered an exchange of like-kind property. Due to the broad definition of like-kind real estate, real estate professionals have utilized this provision to diversify their holdings and defer taxable gain on the disposition of property.
Let’s take a simple example. Assume David holds an investment in a ranch. He purchased the ranch for $200,000 and it is now worth $1,000,000. David has decided he no longer wants the ranch property as an investment but instead is interested in purchasing an apartment building in Chicago. David identifies an apartment building held by Mary in Chicago, with a FMV of $1,000,000. David can exchange his ranch for the Chicago apartment building and under the like-kind exchange rules defer the recognition of the $800,000 gain (1,000,000-200,000). David’s basis in the Chicago apartment building will be equal to his $300,000 basis in the ranch. Therefore, if David sells the apartment building in the future the gain that was deferred will be recognized.
President Biden’s proposal would still allow for 1031 exchanges of real property, but minimize the benefit to only allow a deferral of $500,000 per year or $1 million if filing a married filing joint return. Assuming David in our above example is single, under the Biden proposal, only $500,000 of the gain could be deferred and David would have to report $300,000 of capital gain on his tax return.
Now some may argue that is still a great deal, especially because the $300,000 of gain recognized could be taxed at preferential long-term capital gains rates not to exceed 23.8% under current law. But not so fast. President Biden’s Green Book also proposes that long term capital gains be taxed at the ordinary income tax rates for taxpayers with adjusted gross income exceeding $1 million. In addition, the Green Book also raises the highest ordinary income tax rate from 37% to 39.6% for married filing joint taxpayers with taxable income over $628,300 and for single taxpayers with taxable income over $523,600. Under the existing law, David’s transaction would result in zero state and federal income tax. But under the Biden proposal, David could now have a federal income tax liability of $130,200 when factoring in the ordinary income tax rate and net investment tax ((39.6%+3.9%) x $300,000). In addition, the recognition of income at the federal level could also trigger additional state income taxes if applicable.
This change would have an extremely negative effect on commercial investments and could encourage investors to hold onto real estate longer instead of selling and buying again, which would reduce inventory at a time when inventory is already reduced. It could also decrease incentives to become an investor.
Tip: As you can imagine, completing a like-kind exchange is not a simple undertaking as it can take a considerable amount of time to both identify like-kind property and to complete the transaction. In addition, a direct exchange is not always practical because the two parties involved might not have property the exchanging party is interested in. Therefore, a taxpayer is allowed to utilize a qualified intermediary providing taxpayers more time to identify desired property. There is a strict 180-day policy when identifying and exchanging 1031 property. If a taxpayer fails to complete the transaction within 180 days, the gain is recognized and included in taxable income. A taxpayer interested in a like-kind exchange has 45 days to identify potential replacement properties once the transfer of their relinquished property has closed. The exchanger also has 180 days from the time they relinquished their property to acquire replacement property.
Closing of the Carried Interest Loophole
Many private equity firms invest in real estate — and have been benefitting from a tax break that allows them to reduce capital gains taxes. The carried interest loophole allows profits to be taxed as capital gains at a rate of about 20 percent, instead of as regular income, which is taxed at more than double that rate when state levies and other taxes are taken into account.
By closing this loophole, such firms might decrease their investment in real estate, which could reduce values of high-end homes and decrease competition for homes, making them more accessible to middle- and lower-income individuals. Overall, this could be good for middle-class homebuyers who want to live in these homes and not that great for investors and the wealthy.
The Big Unknown: Inflation
Increasing taxes should give some headwind to inflation, as the price increases we’re seeing are more of a one-time adjustment. As an example, despite the large increase in home prices, there are already signs that the rate of these increases could slow down. Plus, wages are rising, which would balance out increasing prices. So, inflation may impact real estate.
Housing has been a relatively good inflation hedge. According to CoreLogic’s Chief Economist, Frank Nothaft, in general, home prices have increased slightly faster than inflation.
While higher inflation would probably increase the rate of home price appreciation, it could also mean higher mortgage rates. Indeed, inflation can be a double-edged sword. Your house is worth more, but it would cost more to purchase, which could hinder ‘move-up’ buyers. If interest rates trend higher, it would be an additional concern. Still, there is currently strong demand for homes, which could remain for some time due to the huge population of Millennials, who need homes.
If you, or someone you know is considering Buying or Selling an Investment Property in Columbus, Ohio please give us a call and we’d be happy to assist you!
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