Recently, the Department of Treasury released the General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals. The proposals are built around the Build Back Better Act, passed by the House of Representatives on November 19, 2021, but were stalled in the Senate. If you are in the real estate space, it is important to know that many of the proposal’s provisions will negatively impact the real estate industry. Below are the highlights of the proposal that would heavily affect the real estate industry.
Repeal of Like-Kind Exchange Gains Deferral
Like-kind exchange is the most popular strategy used by real estate investors to defer gain on the sale of real estate. As long as criteria are met, gain on the sale of the replacement property is deferred until a subsequent outright sale of the receiving property. The proposal would add a cap of $500,000 for individuals and $1 million for married filing joint taxpayers, on deferred gain on like-kind exchange. Any gain exceeding the threshold would currently be taxable.
Tax Long-Term Capital Gains at the Ordinary Income Rate
Under current tax law, long-term capital gains and qualified dividends are taxed at a maximum income tax rate of 20%. The proposal would tax long-term capital gains and qualified dividends at an ordinary rate for taxpayers, with taxable income of more than $1 million. This means that the tax rate for such gain can go up to 37% or potentially to 39.6% as the marginal rate is increased by the proposal for the tax year beginning after December 31, 2022.
Tax Depreciation Recapture At Ordinary Income Rate
Under current tax law, unrecaptured Section 1250 gain, which in most cases is a depreciation deduction taken on real property, is taxed at a flat rate of 25% for non-corporate taxpayers. The Revenue Proposal would treat such gain as ordinary income to the extent of cumulative depreciation deductions taken in tax years beginning after 2022. Taxpayers with adjusted gross income (AGI) below $400,000 are exempt.
Tax Carried Interest in Real Estate Partnerships as Ordinary Income
A lot of real estate partnerships are structured in a way that certain partners receive “profit interests” or “carried interests” for sweat equity that they put in. When the partnership recognizes long-term capital gain, such gain will pass through to its partners and be taxed as capital gain at the individual partners’ level. Under current tax law, the holding period requirement is extended to three years for certain capital gains passthrough from a partnership. The proposal would tax a partner’s share of income on an “investment services partnership interest” as an ordinary rate, regardless of character of income for a partner with taxable income exceeding $400,000. This means capital gain could be taxed top rate of 37% or potentially 39.6% for individual taxpayers with income exceeding the threshold.
Treat Transfers of Appreciated Assets by Gift or on Death as Taxable Events
Under current law, when appreciated assets, such as real property, are gifted to a donee during the donor’s life, the donee’s basis in the assets is the carryover basis of the donor. There is no realization of capital gain by the donor, nor the donee, at the time of the gift. Capital gain is recognized when the donee subsequently disposes of the asset. Under the proposal, the donor would realize capital gain calculated based on the fair market value at the time of the gift.
Under current law, when real property is passed through to the heir at death, the basis of the real property at the hand of the heir is stepped up to the fair market value at the date of death of the decedent. Similarly, under the proposal, capital gain is realized based on the fair market value at death, and this gain would be taxable to the decedent.
Furthermore, under the proposal, gain on unrealized appreciation would also be recognized by a trust, partnership, or other non-corporate entity that is the owner of the property, if that property has not been the subject of a recognition event within the last 90 years. This provision would apply to property not subject to a recognition event since December 31, 1939, so that the first recognition event would be deemed to occur on December 31, 2030.
Impose a Minimum Tax on Unrealized Gains of High-Income Individuals
The wealth tax is back. Under current law, capital gains are taxable only upon a realization event, such as the sale of capital assets. For tax years beginning after 2022, the proposed would impose a 20% tax on total income, generally inclusive of unrealized capital gains, for taxpayers with wealth greater than $100 million. Real estate would be valued at the greater of the original or adjusted cost basis with the last valuation event from investment, borrowing or financial statements, or other undefined methods. For states in which real estate prices are high, this tax could generate a significant tax budget for taxpayers, especially for those whose wealth is mainly comprised of illiquid assets, such as real estate.
These proposals, if enacted, could significantly impact real estate investment activities. Real estate investors should beware of these potential legislative changes and consider these for future tax planning.
Contact our tax team for more information regarding the proposals and how it would affect your business.
About the Author
So Sum Lee, CPA, Principal
Tax, Real Estate, Technology, Hospitality
So Sum Lee, CPA is a Tax Principal at KROST. So Sum has over 18 years of experience in public accounting and has a wide range of experience in Taxation, as well as servicing high-net-worth clients. So Sum’s area of expertise includes industries such as wholesale, Real Estate investments, and Restaurants. » Full Bio