Biden’s Proposed Tax Changes: What Investors Should Know
This is a repeat of an article from Amanda Han – A CPA specializing in Tax Strategies
Many of you have been anxiously awaiting this information for several months, and it is finally here. We now have more insight into what the proposed tax policies and changes may look like.
According to Accounting Today:
“The biggest tax increase in a generation took a major step forward with proposals of $2.1 trillion in potential tax levies.”
Although these proposed tax changes mostly focus on corporations and the wealthy, it does include some items that may have a significant impact on everyday real estate investors as well. Before we go into the details, here are some main things to keep in mind.
First, these are just proposed tax changes. None of these have been signed into law yet. Many of these proposals may still change and some may not even pass, so don’t make any rash decisions without first speaking with your team of advisers.
Next, tax changes impact different real estate investors in different ways. For example, if the tax rates increase, it does not mean that your taxes will automatically go up. How a change may affect you will depend on your overall financial situation. So, again, speak with your advisers before taking any action.
Now, you may be wondering, if all of these are just proposals that may or may not come to pass, why should you even bother looking into these right now? Well, the reason is because to successfully maximize your tax savings, you need to be proactive. That means making well-informed decisions based on all the information that is available to you right now. Depending on when these tax changes may take place, there could be limited time to make some important decisions. You don’t want to wait until the last minute to even start the process. Also, keep in mind that taxes do not need to be scary. And to be fair, the information we now know as part of the proposed tax changes is not all bad news. There is some good, some bad, and some ugly.
Self-directed retirement account investments
Many real estate investors have used retirement money to invest in real estate rather than in the stock market. With self-directed investing, investors can direct retirement money into several types of real estate deals without incurring current taxes or penalties. Some of the popular vehicles that attract real estate investors include notes, rental properties, and syndications, to name a few. The proposed legislation could prohibit Individual Retirement Accounts (IRAs) from holding private equity, debt securities, and other investments that require the IRA owner to meet certain financial, educational, or licensing requirements.
So, who does this impact? If you use your self-directed IRA to invest in a syndicated deal that requires the investor to be accredited, this proposed tax change can be problematic for you. The new proposed law, if enacted, would require that the IRA dispose of the interest (or move it out of the retirement account) by no later than December 31, 2023. If not done correctly or timely, you could be subject to potential taxes and even penalties of over 50%. If this proposal passes, using self-directed money in most real estate syndication investments may no longer be a viable option in the future.
Another part of the proposal would prohibit the IRA from owning more than 10% of an investment or entity, and the proposal would also prevent the IRA from investing in an entity in which the IRA owner is an officer (regardless of ownership percentage). This means that commonly used strategies such as Checkbook IRA LLCs, trusts, blocker corporations, and joint ventures (JV) may no longer be allowed for IRA investments. For example, your IRA may no longer be able to invest as a JV in a 50/50 deal with another person.
Here is the good news though: You can make your voice heard. Contact your representatives and senators and ask them to vote against this proposed tax change! If you would like to make your voice heard but don’t know where to start, we have put together some information to help you with that.
Tax rate changes
Potential tax rate increases are something we have been hearing about for months now. No big shock here. The highest federal income tax rate may increase from 37% to 39.6%. The highest tax rate kicks in for single taxpayers with taxable income over $400K. However, as a married couple, the highest tax rate kicks in when the joint taxable income is over $450K. As you can see, there is a severe tax penalty for married taxpayers. The proposal not only increases the tax rates but also reduces the income level at which the higher tax rates will start. This means that more people could be paying at the higher rates and more of their income could be taxed at these rates. Why is it important for us to look at ordinary tax rates? When it comes to real estate, many types of income are taxed at ordinary rates. Rental income, property management income, flip income, wholesale income, commissions income, and interest income are some examples of real estate income that is typically taxed at ordinary rates.
Another proposed change to the tax rates that we have been expecting is with respect to C corporations. Although the proposal indicates that the highest C-corp tax rate can increase from 21% to 26.5%, it only impacts C-corps with income above $5 million. For the average real estate investor who uses C-corps to earn flip or property management profit, the proposal would lower the C-corp tax rate to 18% on the first $400K of taxable income. This would be a welcomed tax break if it passes.
Capital gains taxes
As investors, a lot of us have been anxiously waiting for details on any proposed changes to capital gains taxes. The somewhat good news here is that instead of increasing it to the previously discussed 39.6%, the current proposal would increase capital tax rates from 20% to 25% for higher-income taxpayers. A quirky part of the proposal is that the higher capital gains tax rate would be effective for gains recognized on or after September 13, 2021. This means that if you sold some assets prior to this date, you should be able to use the current lower capital gains rate. Alternatively, if you sold some assets after that date, then the proposed higher tax rate may kick in.
The proposal does include a transition period for transactions that were entered into prior to September 13, 2021. An example could be where an investor enters into a sale agreement in August 2021 but closes on the sale after September 13, 2021. They would still pay the lower capital gains tax. Common examples of capital gains include the sale of a rental property, the sale of a primary home, the sale of stocks, and the sale of business assets, to name a few.
New taxes for business income
Another proposed change is for higher-income taxpayers with ordinary business income to be subject to the Net Investment Income Tax. Historically, this tax was assessed only on investment income for high-income taxpayers. Now, for the first time, the proposal is looking to assess this on business income as well. This would be an additional 3.8% tax on top of the federal and state income taxes you already pay. Common types of ordinary income from a trade or business in the real estate realm can include, for example, property management income, flip profit, wholesale income, commissions income, and asset management income. This may impact single taxpayers with taxable income over $400K and married taxpayers with taxable income over $500K.
Roth retirement accounts
Under current law, all taxpayers can convert money from a traditional IRA into a Roth IRA so that the money can grow tax-free going forward. This is true regardless of the taxpayer’s income level. The recent proposal would take that away for single taxpayers with taxable income over $400K and married joint taxpayers with taxable income over $450K. This means that, if enacted, higher-income taxpayers may no longer be able to use the backdoor Roth or mega backdoor Roth strategy with their IRA or 401Ks.
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Any good news?
Actually, yes, there does seem to be some good news for real estate investors. The good news centers on what we didn’t see in the proposed tax changes. For over a year, we have been hearing of the possible elimination or limitation of the popular 1031 exchange benefit. This is where an investor can sell appreciated rental property and replace it with another property and defer the associated taxes. There has been no mention of 1031 exchange in the latest tax proposal, so we feel that no news is good news.
Many investors have also been concerned about whether the tax benefits for real estate professional status, bonus depreciation, and any general business write-offs will be taken away. As with the above, we did not see those mentioned in the proposed tax changes. Again, no news is good news for now.
So now what?
The first step is to step back and take a deep breath. These are currently only proposed tax changes, not the law. It does not mean that the government is taking away everything you have. Tax laws change from time to time, and all that means is that some of your tax strategies and investment decisions may need to change. As new tax laws are enacted, new strategies are developed. The best thing you can do right now is to understand how these potential tax changes may impact your tax plan and investment decisions. The second step is to keep your line of communication open with your team of advisers so that they can help you prepare in advance for any actual tax changes in the coming months. And, of course, the third step is to make your voice heard on these proposals!