3 potential tax law changes that would affect investors
As the presidential election appears to be concluded, commercial real estate investors are now strategizing for the future impacts of new taxation policies under a different administration. We should first preface this article with the fact that these changes/proposals are all preliminary at this point, as there are many factors that ultimately will determine whether these become a reality. That being said, it can greatly benefit investors to be proactive in reevaluating their investment strategies under increased taxation policies.
There are three primary proposed changes to the tax law that would affect commercial real estate investors:
- Raising capital gains from 20% to ordinary income tax rate of 39%;
- Elimination or substantial reduction of tax-free estate transfer upon death; and
- Elimination of 1031 tax-deferred exchanges.
The most probable and immediate implication would be raising the capital gains tax rate to an ordinary tax rate level, which would substantially increase taxes for high earners. On a sale with a gain of $1 million, for example, the tax burden would jump from approximately $200,000 to $400,000. This impact likely could change investor behavior to hold on to assets, especially those where their basis is low compared to the current market value. In these cases, it might make more sense to put a longer-term debt piece on the asset to benefit from the cash flow, and potentially take some dollars out tax-free. If you’re like us and think long-term interest rates will be low for a while, this could be the better economic strategy by a long shot.
Commercial real estate investors seeking to build generational wealth also are strategizing on what to do if the tax-free estate transfer exemption is eliminated or reduced. The current tax law that expires in around four years allows an investor to gift up to around $11.5 million (per individual) in a tax-free exemption upon death. The Biden administration is proposing to reduce it or eliminate it altogether and this could be retroactive to 2021 or commence in 2022. There also is some potential risk of changing the ability to step up an investor’s basis on estate-included assets. Similar to the strategies around capital gains, a solution to this could be refinancing with additional tax-free loan proceeds from long-term debt.
The third potential change regarding 1031 exchanges has not yet become a widely discussed reality, and commercial real estate investors hope that it stays that way. There have been hypothetical discussions to change this tax-deferral method, which would have drastic trickle-down effects on the real estate market. Even in the current pandemic-ridden sales market where acquisition activity has been minimal the past nine months, the majority of transaction activity has come from motivated buyers with tax-deferred exchanges. If and when this becomes a more realistic initiative, it will be important to adjust investment strategies accordingly.
The effects of these modified tax policies will significantly affect the commercial real estate market and transaction volume could be significantly lower if sellers are challenged with a looming tax burden and can’t find suitable alternative investments at a more attractive after-tax return. As a result, refinance transaction volume may easily outpace acquisition financing in 2021.
Insurance companies are ideal lenders for investors who want long-term debt to achieve a combination of cash flow, wealth accumulation and current or future generational estate tax planning. Although banks more frequently are quoting permanent and nonrecourse loans in today’s environment, their standard remargining provisions (loan-to-value stipulations for future appraisals) and recourse components are not ideal for estate planning purposes. Insurance companies most often offer the best blend of nonrecourse debt with estate planning that can be customized and tailored to the borrower’s future objectives. They offer the lowest rates with the longest fixed-rate terms with some at 30-plus years fully amortizing for nonrecourse loans. Insurance companies understand their borrower clients’ objectives and they’re flexible to craft specific language in the loan documents for key principals to replace others in the future as an example.
Proactive investors already are reevaluating strategies with their tax attorneys, estate planners and mortgage bankers to be able to react quickly before modified tax policies are potentially enacted. These steps will help in determining the ideal timing to transact and the best financing solutions on deal-by-deal basis.
Featured in CREJ’s Dec. 2-15, 2020, issue