Karla Dennis, EA, MST & CEO of The Award Winning Tax Accounting Firm Karla Dennis and Associates Inc. — Specializing In Tax Planning
If you are a small-business owner or real estate investor wondering what to expect under the Biden administration with regard to taxes, you definitely aren’t the only one. In the past year, we have all gone through some major changes, and more changes come with a new administration. With this change in administration, I want to make sure you know what you need to be thinking about in regards to your taxes.
One thing business owners are able to take advantage of now is the use of Section 1031. Under this IRS tax code, you are able to defer the tax on an exchange if you start off with a small property and then exchange it for a larger property. However, both properties must be similar enough to qualify as “like-kind,” meaning the property is of the same nature, character or class. You would use the 1031 code if, say, you purchased a property, increasing your wealth in that property, then turned around and sold that property or exchanged it for a larger property. Biden’s campaign team noted last summer that his administration would target “like-kind” exchanges. I am going to explain what that could mean for you.
If 1031 exchanges were eliminated, this could affect your capital gain tax rates as a real estate investor. Let’s say, for example, you purchased a property years ago for $200,000 and now decide to sell it for $500,000; you would then be taxed on that $300,000 gain in property value. Under the current rules, when utilizing Section 1031, if you purchased that same property for $200,000 and sold it for $500,000, that $300,000 would be deferred into the next property, meaning the “taxes due are not forgiven, they are simply postponed until the sale of the new property.” If 1031 exchanges get eliminated, you will start paying capital gains tax at the time of sale and have less money in your pocket to reinvest into the replacement property. When you do pay tax, that’s called a capital gain.
Why is it called a capital gain? Because real estate properties, stocks and other assets are all considered capital assets, and when you sell something like that, you are now benefiting from capital gains tax rates, which can be less than the tax brackets for ordinary income. The capital gains tax rates are the lowest they’ve been in years: They go down as low as 0% with a current max of 20%. That being said, let’s say, for example, your income was over $441,451, and you sold that same piece of property for $500,000 right now. You would pay capital gains on that $300,000 increase in property value at a 20% tax rate. But under Biden’s tax plan, individual long-term gains would increase from a 20% rate to a maximum rate of 39.6% on ordinary income. The new top rate would apply only to people earning over $1 million per year.
That means qualified dividend and long-term capital gains income for these high-earning taxpayers could be taxed at rates as high as 39.6%. Moreso, if you get hit with alternative minimum tax, your taxes could go even higher. This is why capital gains tax rates are so important for real estate investors and high earners. In addition, Biden’s proposals could impact whether real estate investors who earn over $400,000 can deduct losses against taxable income.
Another big item under consideration is the ability for nonresidential real estate owners to depreciate improvements made with regard to their property. The president has proposed eliminating the bonus depreciation rule for commercial property (created under the Tax Cuts and Jobs Act) and reverting to 39-year depreciation for commercial property.
So if you have commercial property, for example, and you’ve added air conditioning or expanded the property, currently you’re able to expense that cost 100%. However, under Biden’s proposal, that cost would get deferred, and you would have to write that off over 39 years. That’s a long time. Generally, anytime we are spending money on our business or on real estate, we want to be able to expense that cost and receive the benefit of it in the same year we incurred the cost rather than writing it off over multiple years.
Right now, these plans are just that — plans. So we’ll have to wait and see what eventually passes. Regardless of whether these proposals come to fruition, taxpayers with real estate contemplating a Section 1031 like-kind exchange should complete their transactions to defer their tax gains prior to enactment of such a provision. As a real estate investor, I want you to find a licensed financial advisor, tax strategist and mortgage lender because they are not all created equal. You need to have a trustworthy team of advisors who can keep you up to date and informed about what you should be doing to position yourself to continue to win.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.