Commercial real estate investing is on the rise, and new laws are being put in place.. With changes stemming from the Biden administration’s agenda on the horizon, you need to be prepared to make the necessary investment adjustments as new policies may affect your business. Note that for this plan to materialize, it requires the approval of Congress, and several amendments will be expected.
Below is an enlightenment on how specific policies of the tax plan will affect you as an investor and business. You will be able to know how to be prepared for these policy changes. It is essential to get in touch with your CPA before applying any available advice on the internet on investing in commercial real-estate.
The commercial real estate industry is closely looking out for the following four tax issues discussed below in detail.
- A set limit of $500,000 on capital gain under the 1031 exchange – Anything over that Set amount will be subjected to capital gain tax.
- Increase of capital gains tax from 20% to the ordinary income rate.
- High-interest rates on carried interest on private equity and manager’s funds
- Taxing unrealized gains exceeds the $1 million mark for an individual and $2.5 million per couple upon death.
Below is a breakdown of the Biden tax plan and its effect on the Commercial Rental Estate, CRE.
Social Security Payroll Taxes
Anyone living in the USA and earns $137,700 and above is subjected to pay a tax of up to 12.4%. One of the Biden tax plan policies proposes increasing social security taxes by 12.4% for anyone earning $400,000. The taxes will not affect anyone who earns less than the mentioned amount in the commercial real estate industry.
Commercial rental estates will have to develop a strategy that will allow them to pay their employees less than the $400,000 mark. For employers with the S corporations, you will need to reduce the employee’s pay below the mark and pay yourself a higher distribution.
Slashing Tax Breaks
A 2020 survey by the N.A.R(National Association of Realtors) informs that approximately 12% of real estate sales were in the 1031 exchange from 2016 to 2019. The Biden tax plan aims to reel in 1031 exchanges on transactions on profits that bypass the $500,000 mark.
Investors use the 1031 exchange of late to sell and buy tax-deferred real estate throughout life. Investors have upgraded to selling their properties through e-sellers from traditional real estate agencies. The exchange allows the property holder to pass their investment to their heir tax-free if they held the investment till death.
The effect of this policy may be far-reaching, especially with the call for an increase in capital gain taxes.
The Biden tax plan is mainly targeting the wealthy in society. Hence, this will also affect the small commercial real estate (CRE) investors. Research done by Realtors shows that small investors occupied 84% of the 1031 exchange. Those investors in the sole proprietorship occupy 47%, and the S corporations hold the remaining 37%.
If the policy is passed in Congress, small businesses looking to exchange property will face tough decision-making and unintended consequences. The rule will also make it hard for small commercial real estate investors looking for a low-maintenance property as they approach their retirement age.
If the 1031 exchange tax increase occurs, many landlords will increase their rent to cover the loss, and the extra taxes are stretched. If the 1031 exchange was eliminated, this could mean that the profits gained from capital gained from tax rates. To elaborate on that, if you purchased a property worth $100,000 years ago and decided to sell it for $400,000, you will be taxed for the $300,000 gained in the property value.
Under the current 1031 exchange rule, the $300,000 profit will be deferred into the next new property. It means that the taxes are not forgotten, but they are pushed forward until the new property sale.
If the 1031 exchange is eliminated, you will need to pay taxes for any capital gained from any property sale. The charge in tax will result in many commercial real estate investors lacking enough money to reinvest into the replacement property.
Lower Estate Tax Exemption
For assets that are above the $11.58 million value, there is a 40% estate tax. According to the Biden tax plan, there is a proposition to raise the tax rate to 45% and reduce the exemption from the $11.58 million to $3.5 million marks. This plan will significantly affect the commercial rental estate investor’s descendants.
If the plan were to pass in Congress, many Americans would need to restructure their living trust and protect it from their children. As said above, these plans seem to target the people who have acquired some wealth to cater for their retirement and leave behind a legacy for their children.
Removing the QBI Deduction
The QBI deduction came into place under the 2017 TCJA. The commercial rental estate investors are currently allowed to pay themselves using the W2 if you have an S corporation. Since the rental estate pays wages to their employees, they can deduct the Qualified Business Income (QBI) on the employee’s taxes. With the new Biden tax plan, the QBI deduction will be eliminated for the adjusted gross income of over the $400,000 mark.
Limiting Itemized Deductions
The Pease Limitation on itemized deduction was no longer working. The new Biden tax plan aims to reinstate deductions. The tax plan aims to reduce the tax benefits from 39.6% to 28% for those commercial rental estate investors earning an adjusted gross income of more than $400,000. The reinstatement plan may be hard to pass through Congress as eliminating the Pease limitation resulted from a recent change implemented in 2018.
Carried interest is the manager’s share of the profit realized – capital interest amounts to the bulk of a fund manager’s compensation. The benefits from the carried interest play a vital role in every private equity investment. The carried interest is meant to align the manager’s interest with the investors and increase performance.
With the latest tax code, the carried interest is considered a return on investment. As a result, the returns are taxed at a 20% rate on the capital gained from the usual 37% regular income tax for commercial rental estate investors earning over $1 million.
If Congress passes the Biden tax proposal, carried interest will be taxed at the ordinary income tax rate. Biden has also increased the rate to 39.5% for investors earning more than $1 million.
Implementing the plan will force fund managers to look for alternative ways to structure fees and cover the increased cost caused by the increase in the carried interest classification.
If the long-term capital gain is raised to 39% for all CRE investors, the carried interest will be canceled anyway.
What Are the Taxes going to be Used for?
Even though people in the commercial real estate industry are panicking about the proposed policies, the taxes will be used for a good cause. President Biden hopes to use the increased tax to help pay for the American Families Plan and the American Job Plan. Even though the Democrats control Congress, they will have a hard time getting the majority votes needed.
Tax Bracket for Ordinary Income
According to the 2017 Tax Cut and Jobs Act, top earners’ tax rates were reduced from 39.6% to 37%. The Biden tax plan suggests bringing the tax rate back to 39.6% and lowering the tax bracket from the recommended gross income of $518,000 to $400,000.
What is next for Commercial Real Estate Investors?
It is not certain that these tax plans are going to go past Congress. With that being said, many commercial rental estate investors are arming themselves with the right strategies to keep them on the map. You should consider checking in with a professional investment advisor, tax planner, or other financial strategist before engaging in any commercial real estate investment. We at Point Acquisitions can help you find the resources needed to perform your appropriate due diligence.
These policies should not make you make an impaired decision as a real estate investor. These changes are meant to happen any day, and your business in the commercial real estate industry should be flexible and ready to make decisions that are in the best interest of your business.
As you have seen above, the increase in taxes in the commercial rental estate industry is for a great cause. It is advisable to seek the help of a professional if you do not understand how the plans are going to affect your business. The tax plan has its benefits and disadvantages. The benefit includes the reduction of taxes for investors earning less than the $400,000 mark. One of the disadvantages includes not having money when you sell a property that has gained value. The money taxed can be used to reinvest in a cheaper property when you reach retirement age.When you think of real estate investment, contact Point Acquisitions before making any decisions on commercial real estate investing.
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