When we last wrote a blog about a potential Biden presidency and his tax plans, it was a what-if scenario. Now that Biden is President, he is acting on his tax policy promises with plans to raise the federal capital gains tax and income tax rates, do away with the step-up in basis for those who inherit real estate, and eliminate what he considers tax breaks for the wealthy.
Here is an outline of several of his proposed tax policies and what they could mean for high-net-worth investors interested in triple-net (NNN) property investments and those looking to use the 1031 exchange.
Biden Proposes Federal Capital Gains Tax & Income Tax Increases
Many of President Biden’s proposed tax changes will reverse the changes to the 2017 Tax Cuts and Jobs Act passed by former President Trump. These and other tax modifications include:
- Reverting the top individual income tax rate for incomes above $400,000 from 37% to the pre-Tax Cuts and Jobs Act level of 39.6%.
- For those with income above $1 million, taxation of long-term capital gains and qualified dividends at 39.6 percent (up from 20%) on assets held more than a year.
- When combined with the net investment income tax (NIIT) on investment earnings, the top tax rate on long-term gains would nearly double from 23.8 percent to 43.4 percent.
- Elimination of the step-up in basis on inherited properties when calculating capital gains taxation.
- Increasing the estate tax to 45%, up from the current highest figure of 40% (on $1 million or more).
According to the Tax Foundation, Biden’s proposed capital gains tax rate would be the highest since the early 1920s. The Tax Foundation further implies this tax hike could have the same impact as it did then, decreasing capital gains tax revenues so much, the government had to start reducing the tax in 1922.
As for high-net-worth commercial real estate (CRE) investors who sell properties, in all but eight states, they must also pay a state income tax on top of federal and state capital gains taxes. When combined, the loss in capital would be significant.
What will Biden Tax Increases Mean for the 1031 Exchange?
If the federal capital gains tax and income tax rates increase, the 1031 like-kind exchange will be needed even more to keep CRE investors investing. However, according to Bloomberg Wealth, “Biden plans to abolish the right to defer certain tax payments on property investment gains of over $500,000.”
What will that mean long-term? Bloomberg cited a 2015 study that argued removing the 1031 exchange tax deferral “could have negative consequences, including reducing liquidity in the market because holding periods would increase. They [study authors] also suggested real-estate investment would decrease, property prices would fall in the short-term, and rents would rise in the longer term.”
If this tax reform goes through, it is likely investors will hang on to their real estate, ultimately providing less tax revenue for the government even though the tax rate is higher. Nobody wins if real estate investors won’t buy, sell, or trade up.
Capital Gains Tax Implications & Step-up in Basis
If Biden’s new tax policies pass Congress, selling investment properties with over $500,000 in profit without the 1031 exchange tax deferral will be costly (43.4% federal capital gains tax). It is also important to look at what this would mean if you were to inherit an investment property.
Currently, when you inherit a property, there is a step-up in basis, which means its value is increased to fair market value, and any capital gains that occurred during the decedent’s life go untaxed. As heir, if you sell the property, the capital gains tax is assessed on the step-up in basis.
For example, if a property was originally purchased for $500,000 and it was stepped up in basis to $1.5 million (fair market value), then you sold it for $2 million, you would pay capital gains taxes on $500,000 profit. If you use a 1031 exchange to trade up to a different, like-kind property, the federal capital gains tax (approximately 20%) is assessed at the new basis and deferred.
By contrast, under Biden’s plan, if you inherit and decide to sell, you will pay capital gains taxes on the old/original basis amount when the asset is sold – the step-up in basis will be eliminated. For example, if the decedent purchased the property for $500,000 and you sell it for $2 million, you would pay capital gains taxes on $1.5 million profit.
Remember, you will not be able to use the 1031 exchange to defer the capital gains tax and buy another investment property as the profit from the sale would be over $500,000.
According to the Tax Foundation, “Raising taxes on capital gains would reduce the incentive to save by reducing the after-tax return to saving. Lower domestic saving leads to lower income for Americans in the future and can lead to lower output by reducing domestic investment. In addition, there are administrative, structural, and transition issues that Biden will need to consider [when he] eliminates step-up in basis.”
The Future of NNN Investing Under a Biden Administration
For decades, the triple-net investment market has been stable. We’ve seen supply and demand fluctuate slightly and cap rates hold steady for the last decade. However, in Q1 2021, cap rates did compress marginally and since the benefits of NNN lease investing are inspiring different types of investors to enter the market, the demand for properties is higher as supply tightens. This is furthered by 1031 exchange buyers who must purchase a property quickly to fulfill their exchange and are often willing to pay a premium to lock up.
Now, with historical capital gains and income tax increases on the horizon, we predict NNN investing and 1031 exchanges will have an urgency not seen in modern times.
So, what does the future of NNN look like? Continued stability. Essential businesses such as dollar stores, convenience stores, fast-food restaurants, auto parts stores, retail pharmacies, and medical clinics are still adding locations, relocating, and making properties available to CRE investors. In fact, many of these companies continue to see record sales and overall growth due to the pandemic, providing NNN investors with properties that supply reliable, guaranteed income in any economy.
How Can I Get into a NNN Property Before the Proposed Tax Laws Take Effect?
If you are interested in purchasing a NNN property investment or you’re in the process of utilizing a 1031 exchange, there’s no time to wait. Experts predict the net-lease market could have one of its biggest years to date in 2021, which is making it even harder for buyers to find available NNNs.
With a market this tight, and commercial mortgage interest rates low, the most reliable, and possibly the only way to buy a triple-net lease property in the near future is to engage a specialized buyer’s advisor. Since the majority of properties are not making it on the open market and those that are, sell right away, you need an advisor who is well-known in the industry. One with a nationwide network of sellers, brokers, and developers; one who is in-the-know when it comes to properties coming up for sale.
To Wrap it Up – What NNN Investors Need to Know About Biden Tax Policy Changes
As a current or future NNN investor, undoubtedly you are aware of Biden’s tax-policy proposals, but you may be unclear of what those changes could mean for your CRE investments and your financial future. If you are considering purchasing a NNN lease investment or utilizing a 1031 exchange, we recommend you start the process as soon as possible.
The easiest way to invest is to reach out to Westwood Net Lease Advisors for a consultation. We specialize in NNN investment properties and 1031 exchanges and are happy to partner with your CPA or tax specialist to ensure your best interests are met. Our goal is to get you into the strongest, most profitable NNN investment with ease and help you reach your financial goals. Our buyer representation – from initial consultation through closing – is free. Contact us for a no-obligation conversation today. 314-997-5227