By Robert A. Briskin
President Biden is expected to release shortly a 2022 federal budget, which will include the President’s proposed tax law changes. With the Democrats currently controlling both houses of Congress, new proposed tax legislation is anticipated to be introduced by the Biden administration into Congress in the fall of 2021. To facilitate the enactment of new tax laws, it is anticipated that the Biden administration will use the budget reconciliation process (thereby requiring only an affirmative 51 votes in the Senate to pass the tax law changes). Most likely, there will be a January 1, 2022 effective date for most of the new tax laws (but there could be earlier effective dates for certain selected tax law provisions). Additionally, there has recently been proposed estate and gift tax law changes introduced into Congress by House Ways and Means Committee member Jimmy Gomez and by Senate Budget Committee Chair Bernie Sanders, known as the “For the 99.5 Percent Act”.
With the large federal deficits generated by the recent COVID-19 relief legislation and the Biden administration’s stated goal to spend further monies to invest in the nation’s infrastructure in the American Jobs Plan, it is anticipated that Congress will increase taxes in order to fund these legislative measures. Potential tax law changes are expected to directly affect real estate transactions with potential changes to capital gains rates and the proposed elimination of Section 1031 tax deferred exchanges.
Described below are some of these proposed tax law changes. It is anticipated that the Biden administration will release further details of its proposed tax law changes in the coming weeks. For your ease of reference, we have highlighted below in yellow those proposed tax law changes that would directly affect real estate.
1. Potential Changes to Federal Income Taxes
(a) Increase to Individual Income Tax Rates. There is a proposal to increase the top marginal income tax rate for individual taxpayers earning more than $400,000 to a 39.6% rate (from the current 37% rate). There would remain the additional 3.8% tax on net investment income.
(b) Increase to Capital Gains Rates When Real Estate is Sold. Currently, capital gains are taxed federally at a maximum 20% rate, plus an additional 3.8% tax on net investment income. California, additionally imposes a state income tax on individuals with a maximum 13.3% rate for income in excess of $1M (California has no lower capital gains rate). There is a proposal to increase the federal capital gains tax on individual taxpayers with adjusted gross incomes in excess of $1 million to a 39.6% rate (plus the 3.8% net investment income tax). Some proposals have even lowered the threshold where taxpayers would lose the benefit of the lower federal long-term capital gain rates, from $1 million of income to $400,000 of income. All of this means that California taxpayers could be exposed to a total tax on the gain from the sale of their real estate of 56.7% if the new proposed federal tax increases are passed. All of these tax proposals are designed to tax high income taxpayers on long-term capital gains at the same tax rate as ordinary income rates. Thus, a California taxpayer selling their real estate investment (or their home) is likely to lose the benefits of the current lower federal long-term capital gain rates. To add further anxiety to taxpayers contemplating selling their business, real estate, or other assets, is the possibility that Congress could make the effective date of a federal capital gains tax increase apply to sales occurring immediately on or after the date of the new tax law’s enactment (rather than the later date of January 1, 2022).
(c) Increase to Corporate Income Tax Rates. There have already been proposals by the Biden administration to increase the corporate income tax rate from its current rate of 21% to a 28% tax rate. There is also a proposal to have a new special minimum tax on corporations with more than $2 billion of defined book income.
(d) Changes in the Foreign Tax on Corporations. In the foreign tax area there is a proposal to allow tax credits for defined jobs brought back to the United States and to eliminate tax deductions for U.S. companies that move jobs and production out of the United States. There is a proposal to increase the tax on global intangible low-taxed income (the so called “GILTI” tax) from its current 10.5% rate to a 21% rate. Additionally, there are proposals to limit the exclusions from the GILTI tax.
(e) Enactment of Environmentally Friendly Tax Provisions. There are proposals to repeal current tax provisions which favor fossil fuels such as the oil and gas industry. Additionally, there are proposed new tax incentives for renewable energy and environmentally friendly businesses.
(f) Repeal of §1031 Tax Deferred Exchanges for Real Estate. The ability to sell investment real estate and reinvest the sales proceeds tax free into other investment real estate has been a part of the tax laws since the inception of the current federal income tax. There is now, however, a proposal by the Biden administration to have Congress repeal §1031 tax deferred exchanges. If §1031 were to be repealed, then owners of real estate would no longer be able to sell their real properties and defer the taxation of the gains from that sale. Instead, the gains on that property’s sale would be recognized and taxed at the time of sale, even if the sales proceeds are reinvested in other income producing real property (and the sale’s gains would potentially be immediately taxed at the higher 39.6% federal income tax rate, plus the 3.8% federal net investment income tax, and plus the 13.3% California income tax because of the elimination of the use of the lower federal capital gain rates for persons with large incomes).
(g) Repeal of §199A Deduction. One of the new tax provisions enacted as part of the 2017 Tax Cuts and Jobs Act (“TCJA”) was §199A, which allowed a deduction of up to 20% of qualified business income (which resulted in an effective tax rate of 29.6%) for qualifying business owners. It has been proposed to repeal §199A or to eliminate its applicability for taxpayers over a certain income threshold (such as over $400,000).
(h) Repeal of Bonus Depreciation Rules. One of the TCJA’s provisions was to increase the benefits of bonus depreciation (allowing the depreciation of 100% of specified assets in the first year). The Biden administration proposes to repeal these bonus depreciation provisions.
(i) Revising Pension and Profit Sharing Plan Provisions. There are a number of provisions being discussed to modify 401(k) plans and pension plans.
(j) Modification of the Current Limitation on State and Local Income Tax Deductions. Currently, there is a $10,000 cap on the amount of state and local income tax deductions (so called “SALT” cap). Proposals have been made to repeal this cap limitation for taxpayers earning less than specified threshold income amounts.
2. Potential Changes to Estate and Gift Taxes
(a) Estate Tax and Gift Tax Exemption. Currently, in 2021 each person has an $11,700,000 unified estate and gift tax exemption (or $23,400,000 for two spouses). This exemption amount under current law is scheduled to be reduced after December 31, 2025 to $5,000,000 plus an inflation adjustment. Some tax change proposals are to reduce in 2022 this exemption amount to $3,500,000 per person (with no inflation adjustments) while other proposals are to reduce this exemption amount in 2022 to the $5,000,000 range. There are also proposals to have a split exemption, so that for estate taxes it would be one exemption amount (such as $3,500,000) and for gift taxes there would be a limitation of a $1,000,000 exemption (which amount of any used gift tax exemption would then be charged against the estate tax exemption at the taxpayer’s death).
(b) Estate and Gift Tax Rates. Currently, there is an estate and gift tax rate of 40%. President Biden is expected to try to raise this rate to at least 45%. Some Congressional proposed tax legislative changes have proposed even higher estate tax rates, such as 45% tax rate for taxable estates between $3,500,000 and $10,000,000; 50% rate for estates between $10,000,000 and $50,000,000; 55% rate for estates between $50,000,000 and $1,000,000,000; and 65% rate for estates above $1,000,000,000. The expected effective date for any changes to tax rates or to estate and gift tax exemption amounts is expected to be January 1, 2022.
(c) Annual Exclusions. Currently, there is a $15,000 per donor per donee annual exclusion (or $30,000 per donee annual exclusion for two spouses), which exclusion amount increases in future years by inflation adjustments. A proposed tax law change is to limit the use of this per donee annual exclusion where gifts are made to irrevocable trusts and to family entities (thereby prohibiting the use of so called Crummey powers of withdrawal to multiple donees).
(d) Proposal to Limit the Use of Intentionally Defective Grantor Trusts. There is a proposal that any assets in an intentional defective grantor trust be brought back into the grantor’s estate at the grantor’s death for federal estate tax purposes. In other words, if a trust were to be considered owned by the grantor for income tax purposes, then under this proposed tax law change that trust’s assets would be subject to a federal estate tax upon that grantor’s death. Another proposed tax law change would have any distributions from such grantor trust to children or grandchildren be considered gifts from the grantor. If these tax law changes were enacted, then it would end the use of intentionally defective grantor trusts as a way to transfer assets to family members.
(e) Proposal to Limit the Use of Valuation Discounts. There are proposals to eliminate minority valuation discounts for nonbusiness assets held in family owned entities, such as limited partnerships and limited liability companies. It remains to be seen whether these proposed tax law changes will affect only entities owning passive assets (such as securities or real estate where the family member does not materially participate) or will this limitation on valuation discounts be extended to family owned corporations and active businesses. A restriction on the use of minority and/or lack of marketability valuation discounts for family owned entities will limit the ability to transfer those entities to children and grandchildren at reduced estate and gift tax cost.
(f) Proposal to Limit GRATs. In order to reduce the effectiveness of using grantor retained annuity trusts (known as “GRATs”) there is a tax law proposal to require that GRATs be for a minimum of ten (10) years, along with other proposals to limit the use of GRATs.
(g) Proposal to Limit the Use of Dynasty Trusts. Many wealthy families put their assets in trusts to continue for multiple generations. The estate tax and generation skipping tax generally apply only to gifts in trust to the grantor’s children and grandchildren, while great grandchildren and later generations can receive distribution of the dynasty trust’s assets free of estate and generation skipping taxes when an upper generation person dies. There are proposed tax law changes to limit the tax benefits of these “dynasty trusts” by making these dynasty trust subject to a generation skipping transfer tax after 50 years.
3. Proposal to Eliminate Assets’ Step-Up in Income Tax Basis at Death
Under current tax laws upon a decedent’s death that decedent’s owned assets’ income tax basis is stepped-up to those assets’ fair market values (thereby eliminating the income tax on those assets’ appreciation to the date of death). There are proposals to eliminate a decedent’s assets’ step-up in income tax basis at death or to limit the income tax basis step-up to only a specified dollar amount. The result would be that estate beneficiaries would be exposed to both an estate tax and an income tax on the real estate which they inherit.
4. Proposed Effective Dates of Tax Law Changes
Generally, the proposed effective date for any enacted tax law changes is expected to be January 1, 2022. However, some of the proposed tax law changes (for example, higher capital gains rates on the sale of an asset) could be made effective to an earlier date, such as the date of the enactment of the new tax legislation.
Robert A. Briskin is a Certified Specialist in Taxation Law by the State Bar of California. He is a frequent speaker before accounting groups, Bar groups and other professional associations. He is an AV rated attorney by Martindale-Hubbell.
A list of Robert Briskin’s articles includes: Estate Planning for the Family Business, USC Probate and Trust Conference, 2000; The Treatment of Cancellation of Debt Income by S Corporations, Los Angeles Lawyer, June 2000; S Corporations: Supreme Court to Decide Whether COD Income Increases Basis, The Tax Advisor, September 2000; Supreme Court Reverses Tenth Circuit in Gitlitz, Taxes, the Tax Magazine, March 2001; Fair Exchanges, Los Angeles Lawyer, September 2003; Preserving the Tax Benefits of Family Limited Partnerships California CPA Magazine, July 2003; Like-Kind Exchanges-Common Problems and Solutions The Tax Advisor, April 2005; Planning Strategies to Sell Real Estate at Lower Long-Term Capital Gains Rates, California CPA Magazine, November 2005; Family Limited Partnerships – Operational Issues, California CPA Education Foundation – August 2007; Loan Workouts for Commercial Loans, California CPA Magazine, June 2009; and Estate Planning for Real Estate, California CPA Education Foundation – November 2009.
Robert Briskin has over 30 years of experience in representing clients on major corporate, business and real estate transactional matters, and is highly respected for his creativity in business and tax planning. He has a B.A. Degree from the University of Michigan, a J.D. Degree from Wayne State University and an LL.M. Degree in Tax Law from the New York University School of Law.