It’s been roughly over a year since President Joe Biden took office – and he certainly has plans to make significant changes across the board.
Although his administration has had difficulty getting their Build Back Better plan passed through Congress, it’s worth pointing out some of his proposed tax law changes. These changes are meant to help fund his $1.8 trillion American Families Plan, a significant part of Biden’s Build Back Better plan.
As a real estate investor, you’ll want to pay close attention to whether Biden passes his agenda in Congress as it could affect your real estate investments.
The following are a few of the proposed changes that could affect your real estate investment strategy.
An Increase In Capital Gains Taxes
Long-term capital gains refers to any profits you make on real estate that you’ve held for over a year. The rate that you’re taxed at depends on your total taxable income.
For instance, if you made less than $41,675 for the year (and filed as a single individual), you won’t have to pay any taxes on your capital gains. If you make between $41,676 and $459,750, you’ll be required to pay capital gains taxes at a 15% rate.
Currently, if your taxable income exceeds $459,750, the maximum tax rate you’ll have to pay on any capital gains is 20%. Keep in mind that this is for single filing status–the numbers differ a little if you’re married and filing either jointly or separately, or if you’re the head of the household (although the tax rate is still capped at 20%).
Biden’s Tax Proposals On Capital Gains
President Biden’s proposal would increase the maximum capital gains tax rate. Specifically, if you have an adjusted gross income that exceeds $1 million, then any capital gains you generate will be taxed at 39.6%.
Although this proposed change will only affect high-earning real estate investors, it would still almost double the capital gains tax rate at this threshold. As you can imagine, this may have a significant impact on the real estate market as a whole since it could change people’s real estate investment strategies.
A Change To The 1031 Exchange
The government implemented the 1031 exchange to encourage real estate investors to reinvest in real estate, thereby maintaining the strength of the real estate market. The 1031 exchange allows you to roll over the proceeds of your sale into another real estate investment so that you can defer any capital gains tax owed on the initial sale.
To qualify, you have to invest in real estate that is “similar or related in service or use” to the previous property that you sold. Additionally, you must designate the replacement property in writing within 45 days of the initial sale, and you must close on the property within 180 days of the sale.
Biden’s Proposal To Change The 1031 Exchange
At the moment, there is no limit to the amount of capital gains you can reinvest under the 1031 exchange. However, Biden is proposing a limit on the amount of capital gains that can be deferred using the 1031 exchange. The proposal is to limit capital gains you can invest to $500,000 for individual filers and $1 million to investors who are married and filing jointly.
For example, if you earn $1 million in profit from the sale of real estate within a year, you would only be able to defer half of those capital gains under the 1031 exchange. This means, if you are classified as an individual filer, you would be required to pay capital gains taxes on the other half.
In this way, the government is able to generate more tax revenue.
Impacts On Real Estate Investing
Biden’s intent is to tax top-dollar investors at a higher rate and use the tax revenue to help fund his American Families Plan. The proposal will tax the rich to help poor and middle-class families, and there’s no doubt that his proposal will affect real estate investors from the top down.
However, it’s worth noting that while there could be some negative consequences, there are a few potential benefits to Biden’s proposal for investors as well.
1. Investors May Pay Higher Taxes
Successful real estate investors will likely be hit hard by the capital gains tax increase. Doubling the tax to almost 40% may cut profits almost in half for high-earning investors.
Imagine if you’re an investor who finally sees some success for the first time. You’ve been making decent money for a few years, but finally one of your real estate investments pays off, and you make a cool million.
With the proposed changes to the tax laws, you might be left with roughly $600,000 instead of $800,000 after tax. As an investor, it will take you much longer to reinvest that money and build upon your initial success than it would before.
As a result of the proposed changes to real estate investing, high-earning investors will likely have to pay higher taxes.
2. It Could Be More Difficult To Defer Taxes
The 1031 exchange doesn’t just benefit top-dollar investors. It helps smaller investors who need access to as much money as possible to continue investing in new properties.
A smaller investor will need access to funds to continue investing and building their portfolio. If it becomes more challenging to defer their capital gains taxes under the 1031 exchange, they may have less access to funds, limiting their investment opportunities.
3. DSTs May Become More Appealing
If 1031 exchanges were to become more limited, investors may turn to Delaware Statutory Trusts (DSTs). A DST is a type of real estate co-investment trust that allows you to purchase fractional interests in bigger properties. The trust is run by a trustee who is responsible for the fund’s decision making and who is the sole borrower on the property.
The reason DSTs may increase in popularity is because they have low minimum investment amounts of around $100,000 and as low as $25,000.
As a result, any gains you earn on a single DST will likely be below the tax deferral limit of the proposed changes to the 1031 exchange.
Because you can invest in multiple DSTs with varying sale timelines, any gains you earn in any one year may not exceed the limit of the proposed 1031 exchange.
4. Property Prices Could Go Down
If the proposed changes are passed, it could affect the demand for real estate. Investors will have to plan their real estate investments more strategically. For example, they may limit the number of properties they buy in a year to avoid exceeding certain tax thresholds.
Moreover, if the 1031 exchange is limited, investors may not reinvest their profits into additional real estate holdings either. As a result, real estate investing may decrease, driving property prices down.
While this could hurt the value of an investor’s existing real estate holdings, it would also make investing in new properties more affordable at the same time. For long-term investors, this could certainly be a net positive.
Successful Investors Stay Up-To-Date With Potential Tax Law Changes
Identifying good investment opportunities and capitalizing on them is only one facet of being a successful real estate investor. To be successful over the long term, you also need to stay up-to-date with all the latest tax law changes – even proposed changes that haven’t passed yet.
Doing so will allow you to plan for possible worst-case scenarios and help you maximize your profits despite any changes passed into law.
As such, be sure to keep an eye out on Biden’s proposed tax law changes and plan ahead to maximize your bottom line.