Good News for America - Bad News for Your Wallet

From Ronald Reagan to today, the American tax code has created an ever-lowering tax regime for the wealthy. Is Joe Biden’s tax proposal the end of the Reagan era tax code?

Biden’s Plan: What Is He Proposing?

Although the plan is complex, and includes many provisions, we can summarize the relevant portions for our analysis by looking at the changes from two key perspectives: as increases to nominal tax rates, and as reductions to the ability one has to mitigate rate increases, creating a higher effective tax rate for many high-income earners.

Rate Increases

For those with more than $400,000 of taxable income, the nominal top tax rate increases under Biden’s plan from 37% to 39.6%. This is a reversion to the Obama-era rate. In addition, the proposal includes a 12.4% social security tax to earned incomes above $400,000, which would make the marginal income tax rate 52%. Even more significantly for investors, long-term capital gains for those with taxable income above $1m will be taxed under the plan at the ordinary income rate of 39.6% instead of the current 20%.

Reduced Tax Mitigation Strategies

In addition to increasing the nominal tax rates, the plan eliminates a number of tax mitigation strategies that have kept effective tax rates low for high-income individuals. Biden is proposing maxing out the benefit of line item deductions at 28%.

Real Estate: What Changes, and What Likely Stays the Same?

There are four main things that make investing in real estate highly tax-advantaged. First, bonus depreciation, with which one can write off the full cost of new equipment or land improvements in the year in which it is purchased or in the year in which it is completed. Second, what is commonly referred to as a 1031 Exchange: when one sells real estate which is designated as investment property, one has the option of trading that property into a replacement property without currently paying capital gains tax, but having it deferred to a future taxable sale of the replacement property. This is known as a tax-deferred exchange under Section 1031 of the tax code. Third, investors in residential real estate are allowed to write off the value of a building over a 27.5 or 39-year period in straight-line depreciation.  And fourth, the step up in basis upon death has long been a policy that preserved generation wealth and enabled inheritors to continually depreciate the same assets. The first item, bonus depreciation, is quite clearly under attack in Biden’s proposal. One should assume that bonus depreciation will not continue beyond the 2020 tax year. The second and fourth items, the 1031 exchange and step up in basis upon death, have also been specifically identified as programs or policies that will be targeted for elimination. Straight line depreciation is likely not going to come under attack completely. However, there may be some changes around the edges, such as a revision of the number of years across which the depreciation must be amortized.

To begin with the depreciation changes, it appears likely that the bonus depreciation rules of the Trump tax plan will be eliminated, but our tax advisors at Novogradac argue that we are unlikely to see a complete elimination of straight-line depreciation. Straight-line depreciation is unlikely to be adjusted as it is how companies have depreciated their assets since the beginning of the tax code based on the asset’s useful life. SL depreciation has long been the standard, and policymakers have used accelerated depreciation methods or bonus depreciation to give businesses a quicker write-off as a strategy to encourage the purchase of assets in order to stimulate the economy. On the whole, this change merely reverts to pre-Trump policies.

The 1031 exchange is typically a tool of smaller property owners and individuals, and so the removal of that benefit will probably not limit the ability of larger investors or corporations to dispose of assets. However, the elimination of the 1031 exchange could still have significant impacts upon the real estate investing business, as it may reduce the number of properties going to market. On the margin, fewer assets will trade because trading into low-risk cash-flowing buildings will become a much less valuable business proposition when the trade triggers a significant tax bill. If, as we suggest below, market forces and this tax policy might increase demand for investment real estate, then removing the 1031 exchange from the tax code may correspondingly decrease supply. As a result, this could strengthen market effects and increase property values, particularly in core urban markets.

Real Estate Income (and Opportunity Zone Benefits) Become More Valuable

One can summarize the benefits of real estate investing as falling into three main categories - they Defer tax liabilities, Reduce the effective tax rate, and Eliminate some or all of the eventual tax bill.

Defer

The benefits of investing in real estate are amplified by these proposed tax policy changes. Assuming Biden’s plan were passed as published, it would make the marginal tax rate for a California taxpayer 65% above $400,000. As a result, one would need to earn $2.86 in regular income to net a dollar in their pocket. Thus, each depreciation-sheltered dollar that an investor can earn in real estate is the equivalent of $2.86 in an alternative investment. Said differently, a real estate investment paying out a 6% yield will be the equivalent of taxable investments paying 17.14% yield.

Eventually, one has to pay depreciation recapture tax at the sale of a real estate asset, but there are huge return advantages to enjoying the benefit of that cash throughout the investment hold. And the longer somebody holds their investment, the greater the benefit.

Reduction

Currently, there is a 12% differential between the regular income tax rate and the depreciation recapture tax rate. It is unclear whether this reduction will hold. Moreover, the investor who has over $1 million in taxable income will not have this differential at all as their long-term capital gains will be taxed at 39.6% under the proposal. This benefit could become as great as a 14.6% reduction in the tax rate on depreciation-sheltered income for taxpayers under $1 million of taxable income, or could fall to zero.

Elimination

The opportunity zone program is currently the only program that allows for the complete elimination of depreciation recapture tax as well as a partial reduction and deferral of the federal capital gains tax. In other words, it’s a workaround of the Biden tax plan, giving investors the benefit of both the deferral, the reduction, and the elimination of tax liabilities.  

With a potential increase in the capital gains rate, the ability to lock in any capital gains tax reductions or to entirely eliminate the eventual tax at sale of the assets becomes even more valuable to investors. Prior to this plan, the cumulative Ozone benefits created approximately $770k for every million dollars invested. With an increase in the capital gains rate, investors in our opportunity zone program would enjoy over $793k of cumulative tax savings per $1m invested.

Conclusion - Behavior Changes and Asset Classes

No one should allocate capital based solely on taxes. The underlying investment must be sound. However, investors must also consider the actual dollars that end up in their pockets, which means that taxes matter, and are about to matter more. One wants to be very cautious about allocating capital into sectors of real estate that may have underlying cyclical or COVID-related vulnerabilities. As we have noted in recent newsletter along with various market observers more expert than ourselves, we believe that multifamily will be the winning asset class for reallocated capital in response to these tax code revisions.  

Within multifamily, luxury rents have taken a hit during this period, whereas entry level rents have held up significantly better. America (or at least the Bay Area) was substantially underhoused before this pandemic occurred, and that underlying structural demographic trend makes the Bay Area and multifamily overall more stable places to allocate capital. This tax plan, although it appears on the surface to be bad news for real estate, could actually make stable real estate more valuable relative to other fixed income alternatives. The tax benefits that remain to real estate are significant, and as the market begins to see the Biden tax plan as a likely future, we expect to see a significant reallocation to real estate investment. Those investors who come to that conclusion before the rest of the market catches up could benefit from first mover advantages.  

Whether from a tax perspective, from a cyclical perspective, or from a demographic perspective, residential real estate investing benefits from significant advantages. There is no better place we could think to allocate our capital. If you’re interested in learning more about our investment strategy or our current fund, please reach out. We’d be happy to set up an initial call to see how we can help you meet your investment goals.