On May 28, 2021 the US Treasury Department released the 114-page, 2022 budget “Green Book” (full title “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals”).
As outlined in the Administration’s April 28, 2021 announcement of a $1.8 trillion spending package named the American Families Plan, the Green Book details various proposals aimed at increasing revenue and “the progressivity of the tax system.” One of the areas hardest hit is investments in real estate. For example, one of the proposals is the effective repeal of the tax deferred treatment of like kind exchanges of real property, which provision has been in the Code for 100 years.
Another change adversely affecting real estate is the ordinary income treatment of capital gains from carried interests in real estate (and other investment) partnerships. A third proposal would cause income from the sale of real estate to be taxed at ordinary income rates effectively eliminating Section 1231 treatment for real estate, which has been in the Code since 1942. Additional proposals include denying higher income taxpayers the preferential tax rates afforded to qualified dividends and long term capital gains on non-real estate assets and the introduction of taxable realization events on unrealized appreciation of capital assets such as transfers by gift or upon death (effectively eliminating step up asset basis upon death).
Like Kind Exchanges
The proposal addressing like-kind exchanges does not eliminate like-kind exchange deferral entirely. It allows for the deferral of gain up to an aggregate amount of $500,000 for like-kind exchanges of real property for each taxpayer annually ($1 million for married filing joint filers). Gains in excess of these amounts would be recognized in the year the like-kind exchange property is transferred. It remains to be seen whether this provides an opportunity to creatively divide real property interests with this threshold in mind. Partial dispositions could, in theory, be made over a period of time to ensure gain is eligible for deferral. Additionally, the proposal does not address how the limitation would apply to partnerships and other pass-through entities, which may provide additional planning opportunities and prove difficult to restrict.
The proposal would be effective for like-kind exchanges completed in taxable years beginning after December 31, 2021. This would seem to apply irrespective of when the exchange was begun. The proposal could have a wide-ranging impact on the real estate industry which, on an annual basis, typically engages in like-kind exchanges totaling billions of dollars.
The Green Book contains a proposal that would treat capital gains derived from the ownership of profit interests in partnerships received in exchange for services – known as carried interests – as ordinary income for taxpayers with income above $400,000. As an anti-abuse measure, the proposal would extend to sales of derivative interests and convertible debt for taxpayers holding carried interests. This proposal could impact the negotiation of real estate deals, which often rely on carried interests as a means of compensation for managing members. This provision would be effective for tax years beginning after December 31, 2021.
Changes in Tax Rates
Under the proposal, capital gains would be taxed at the highest ordinary income tax rate as well as the net investment income tax for income in excess of $1 million dollars, or $500,000 for married individuals filing separately.
Currently, the highest effective tax rate is 37%, but a separate proposal would raise the highest bracket to 39.6% (43.4% including the net investment income tax) for taxable years beginning after December 31, 2021.
To prevent taxpayers from planning to recognize gain prior to the rate increase, the proposal would be effective for gains recognized after “the date of announcement.” It is currently unclear as to exactly what date is meant by the date of announcement, although it could be April 28, 2021 which is the date that the American Families Plan was announced by President Biden. While retroactive tax increases have been ruled constitutional by the Supreme Court, they are generally disfavored by Congress, who would have to deal with angry constituents. While no guarantee, history suggests that any tax increase on capital gains will apply only prospectively, either when legislation is introduced or enacted. Accordingly, if investors plan to sell otherwise in a taxable event in 2021, there may still be an opportunity to have the capital gain be taxed at the current rates.
Net Investment Income Tax and Excess Business Losses
Other proposed measures impacting real estate investors include an expansion of the 3.8% net investment tax to activities in which the taxpayer materially participates (which is currently exempt), and a proposal to make the limitation on excess business losses permanent, which would limit the ability of taxpayers to utilize real estate losses to offset nonbusiness income such as wages and investment income.
Centralized Partnership Audit Regime Bipartisan Budget Act (“BBA”)
The proposal also includes a welcome change to the partnership audit regime enacted in 2015, known as the BBA. Partnerships subject to the BBA are no longer allowed to amend previously filed partnership tax returns. Instead, partnerships must file an Administrative Adjustment Request (“AAR”) to report changes to the IRS, which is recognized by partners in the year in which the change is reported.
Currently, if changes reduce taxable income below zero in the year of change, the excess is not allowed as an overpayment and is essentially treated as a nonrefundable tax credit.
Under the proposal, the excess will be treated as an overpayment and will be allowed as either a refund or a payment of estimated taxes for future taxable years. This could encourage participation in the regime and may allow real estate investors the full benefit of changes to the code under recently enacted measures. At this time, it is unclear whether it will apply to overpayments stemming from taxable years prior to the enactment of this proposal.
Affordable Housing Incentives
In an effort to incentivize the construction of affordable housing, the Green Book includes a proposal as part of the American Jobs Plan to introduce an additional type of Housing Development credit alongside the existing Low Income Housing tax credit, targeting areas with higher housing costs relative to median income in low poverty areas. The proposal would also expand the existing tax credit by allowing for an increased basis factor when calculating the dollar amount of the credit.
Estate Tax Changes
As part of the changes in the treatment of capital gains, the proposal would expand mark to market treatment to donors or deceased owners of an appreciated asset causing the realization of a capital gain at the time of transfer, equal to the difference between the fair market value of the asset on the date of gift/death and the donor’s/decedent’s basis in the asset (with an election for certain transfers at death of illiquid assets such as real estate and partnership interests to be paid over 15 years). For a more detailed discussion, please see Mazars’ Tax Alert Biden Administration’s Budget and Treasury Green Book Released, Providing Details on Estate and Gift Tax Proposals.
There are a number of tax planning ideas that are available to real estate owners to minimize the effects of these proposals should they be finalized. One alternative is contributing property to a partnership or an UPREIT instead of selling it. These entities offer the contributor the benefits of tax deferral, diversification, professional management and liquidity. The partnership/UPREIT structure provides flexibility in allocations of income and deductions and distributions of cash and property.
Another alternative is the use of Section 467 leases to obtain tax deferred liquidity. A section 467 lease is generally a lease that provides for either increasing or decreasing rents or prepaid or deferred rents over the terms of the lease. A properly structured section 467 lease can provide the owner with significant cash upfront without significant taxable income.
A third alternative is to reinvest capital gains into “Qualified Opportunity Zone” investments. The product of the 2017 Tax Cuts and Jobs Act, Congress provided three incentives to promote investment in certain low-income communities and adjacent census tracts (Qualified Opportunity Zones, “QOZs”). A properly structured Qualified Opportunity Fund (QOF) investment can have three benefits; (i) deferral of capital gains until December 31, 2026; (ii) 10% exclusion for gains reinvested in 2021 and (iii) permanent exclusion of all gains from the Qualified Opportunity Funds investment held for at least 10 years.
These proposals could significantly affect business transactions. The increases in tax rates on ordinary income coupled with the treatment of qualified dividends, capital gains and income from carried interests as ordinary income and the disallowance of tax deferred like-kind exchanges could dramatically affect the after-tax returns of real estate owners and investors, reducing their willingness to invest in infrastructure and other assets.
There is still a long road ahead before the enactment of any of these proposals. They, along with others, will be the subject of negotiation among all the parties involved and, even if not passed as part of the first round of legislation, could be part of subsequent rounds.
Please contact your Mazars professional for additional information.