Joe Biden and President Trump continue to reel in headlines, but Biden’s proposed economic plan is reverberating through out the CRE world. The reason why is because it contains an agenda to tax capital gains on inherited real estate.
The proposed plan is in fact the opposite of what current law states while many say it will significantly undercut profits.
“The [proposed] change would end the process of real estate heirs taking probated property on a stepped-up basis and instead require them to pay capital gains taxes on all appreciation that accrued on the property before their inheritance, according to Erica York, an economist with the Center for Federal Tax Policy at Tax Foundation.”Bisnow.com
Additionally the course of action will also implement a much steeper capital gains tax rate of 43.4% for some people, compared to the current upper limit of 23.8%.
According to York, “Under existing law, if someone purchased a property when it was valued at $1M and died when it had reached a fair market value of $5M, the owner’s heirs would inherit the property at a stepped-up basis of $5M. As a result, heirs under current law do not have to pay capital gains on the $4M in appreciation that accrued before the original owner’s death, and if they were to sell the property down the road, they would only pay capital gains taxes on any value above $5M.”
By contrast under the Biden Plan—using the same example—heirs will be fully responsible for capital gains taxes on the $4M of appreciation, and also on any profit above the $5M once the heir sells the property. In other words, the inherited real estate will be sandwiched by capital gains taxes on the appreciation before acquisition, and upon selling of it.
To say that profits will be diminished is an understatement. The possibility of ending the stepped-up basis model is spurring seller and trading activity. Those who are expected to inherit things such as family trusts, ranches, huge pieces of land or are simply over the $1M income threshold, may be planning for sooner rather than later.
“This would essentially add a fourth tax bracket to the capital gains schedule of 39.6% on income above $1M, meaning the top rate could reach 43.4% when we include the 3.8% net investment income tax,” York said.
Eric Toder, co-director of the Urban-Brookings Tax Policy Center at the Urban Institute, introduces the idea that real estate inheritance will proceed in a different manner if Biden wins. Having said that, it may only affect people who make more than $400K a year, or transactions involving high-priced assets, therefore, middle-class income earners may not be affected.
Toder reveals certain exemptions that will limit which type of property will absorb the brunt of capital gains taxes by dispelling nuances in the law, for example, the first $200K of gains for married couples, or $100K for singles, will be exempt.
“If your other income, including the capital gains, is less than $400K, then you are not affected by this proposal,” he said.
“And for the higher 39.6% proposed capital gains rate to kick in on inherited property, the heir would have to have a total income, including any capital gains, of more than $1M; otherwise, the lower 20% tax rate applies for those with incomes over $400K but under $1M, Toder noted.”
The picture is much more bleak for heirs of commercial properties however. Commercial assets are lucrative by nature. They appreciate sometimes at alarming rates and have high property values. Because the proposed plan isn’t totally refined at the moment, CRE investors and heirs of commercial property could be facing heavy tax bills; among other uncertainties is if death will be considered a taxable event.
With no real road map to affirm much of anything for commercial constituents, Bisnow reports a couple possibilities including a carry-over basis of inheriting real estate. What this means is that heirs will not have to pay capital gains taxes on appreciation at the time of acquisition, but will do so upon selling the inherited property; Or be able to spread their taxes out over time.
Tony Trahan of tax advisory firm KE Andrews, believes if the plan goes through it will have an enormous impact on owners of commercial property.
“Think about somebody or a family that has held multifamily assets for years and years, and they have doubled or tripled their appreciation,” Trahan said. “The heir that inherited it would have to figure out how to come up with that income tax on something that has tripled, so it’s a difficult thing for sure.”