Rod Khleif Real Estate Investor, Mentor, Coach, Host, Lifetime Cash Flow Through Real Estate Podcast.
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As multifamily investment coaches and mentors, we are often quick to cite the tax advantages of an investment in a multifamily asset, and there are many. But, a slate of proposed tax changes under the new presidential administration could reduce or eliminate some of these advantages. For this reason, it is important that investors increase their awareness of the proposal and start to formulate a game plan should it ultimately be passed into law.
Note: To be clear, this article does not offer tax advice. The changes discussed are still in the proposal stage and there is much uncertainty about whether they will ultimately become law.
In order to understand how the proposed tax changes could impact multifamily profitability, it is first important to understand the tax advantages under current IRS rules.
What Are The Current Multifamily Tax Advantages?
There are two prominent tax advantages to a multifamily investment. One has to do with the long-term capital gains tax rate, and the other has to do with a type of transaction known as a 1031 exchange.
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The difference between the price paid for a multifamily property and the price that it is eventually sold for is known as a “gain” and it is taxable. If the property is held for less than one year, the taxes paid on the gain depend on an individual’s tax bracket, which ranges from 10% to 37% under current rules. However, if the property is held for more than 12 months (most are), the gain is taxed at a lower rate, which can range from 0% to 20% depending on the individual’s tax bracket. For individuals whose tax bracket is higher than the 20% long-term capital gains tax rate, there is a potential for significant tax savings.
Second, investors have an option to defer capital gains taxes by reinvesting their property sales proceeds in another property that is considered to be “like-kind.” This type of transaction is known as a 1031 exchange, and there is no limit to the number of times it can be done. In theory, an investor could defer capital gains taxes indefinitely with a series of successive 1031 exchanges. Doing so allows their capital to grow tax-free over time, which is also a major advantage.
In a proposal made earlier this year, President Biden’s administration outlined plans to drastically scale back these advantages as a way of funding the administration’s economic agenda. There are two key points.
Proposed Changes To 1031 Exchanges
Under the plan, the Biden administration seeks to make two major changes to the 1031 exchange program.
First, the administration is seeking to put a cap on the dollar amount of profits that can be deferred in a 1031 exchange. At present, there is no limit. Under the proposal, profits of more than $500,000 for those filing as single taxpayers ($1 million for couples filing jointly) could not be deferred. While this may not impact many small investors, it is likely to have a significant impact on medium-sized and institutional investors.
Second, another major benefit of a 1031 exchange is that it allows the heirs of an investor to inherit the property at a “stepped-up basis” that is equal to the market value at the time of death. The net effect of this is that the property can be passed to beneficiaries tax-free. The Biden administration’s plan seeks to eliminate this benefit on properties with gains of $1 million or more for single taxpayers ($2.5 million for couples filing jointly) and require heirs to pay taxes on the outstanding gains at the time of death. For large properties with significant gains, the tax bill could be sizable.
The impact of these proposals is difficult to quantify. But, a 2021 analysis (download required) by Ernst & Young indicates that the broader impact of these changes could be significant. With the current like-kind exchange rules, the firm estimated the following for 2021:
• “In 2021, at the businesses that make use of the like-kind exchange rules, 260,000 workers earning $11 billion in wages and benefits would be supported directly by the like-kind exchange rules.”
• “Like-kind exchange rules would directly generate $22.4 billion in value added in the United States in 2021.”
Further, the firm states, “Imposing a tax on continuing investment would discourage and slow the velocity of investment, resulting in market illiquidity and increased cost of capital, with impacts on asset values and rents.”
Based on this research, it is clear that the impact of these rules would go far beyond reducing the profitability of a multifamily investment alone. They could have a detrimental impact on commercial real estate investments in general.
Long-Term Capital Gains Taxes
The second major component of the proposal is to raise the top level of the long-term capital gains tax rate from 20% to 39.6% for households making $1 million or more. The impact of such a change is clear; the tax bill upon sale could nearly double, which could discourage investment activity and increase holding periods due to reluctant sellers.
What Should Investors Do To Prepare For Changes?
To be clear, these are proposals only and will likely face stiff resistance from the commercial real estate industry and from congress members who would oppose such a change. However, that shouldn’t stop potential multifamily investors from preparing, should they ultimately become law. I offer two tips:
First, prepare. Research the specifics of the changes, understand the potential impact and plan for how investment strategies may change. Those who are best prepared to navigate these new rules may find themselves benefitting from new opportunities.
Second, research alternatives. While the proposals target 1031 exchanges specifically, they do not (at present) appear to target other popular tax deferral programs such as Delaware Statutory Trusts or Opportunity Zones. Investors should increase their familiarity with these programs and be prepared to act accordingly if the tax changes are passed into law.
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