2022 Proposed/ Potential Tax Changes for Property Investors
Currently, the taxes are at one of the lowest points historically. There is only one direction for tax rates to go- up! By the end of the year, we will have a little more clarity on the direction of the taxes and perhaps something passing through Congress and getting signed into law by Joe Biden.
1031 exchanges- which are available to real estate investors whereby they can sell one property and purchase a replacement property or another piece of real estate for investment purposes and defer the gain on the sale of that original piece of property that they held.
Let’s say you purchased a house at $250,000, it is now worth $400,000.
If you were to sell that property, you would have to pay tax on $150,000 of gain.
Instead, if you do a 1031 exchange, what you do is sell that property making sure that you qualify for all the parameters of section 1231 and buy a replacement property. So after buying another residential real estate property to rent out. If you’re able to do that, then you can take that $150,000 gain that you have and defer it into the purchase price of your new property. People can do these 1031 exchanges to push off paying taxes for years. One proposed change to the tax law is the potential elimination of this 1031 exchange. That would mean even if you sell your original property, your original investment property, and replace it with another property, you’re still going to have to pay tax on that $150,000. So as an investor, you’re not going to have as much money available to go out and buy replacement property.
What is being said about the 1031 exchange is that there might be a complete elimination of 1031 exchanges. Another proposal is that they might limit it so that you can only defer a certain amount of gain into your next property and the third proposal is that if your income is below a certain threshold you’ll still be allowed to do a 1031 exchange. The problem with the third proposal is that when you sell property, you have a gain that is likely to push you to whatever threshold there is, so 1031 won’t be available to you. If you are planning to do 1031 exchanges, it may be better to do it this year versus holding off until 2022 because if this goes into effect, and it’s not so clear whether they will make it retroactive, it would affect your game plan.
What would be the impact/ consequences of Joe Biden’s tax plan? When will the new taxes go into effect?
When tax laws are passed, they can be made effective at any point in time. Generally, new laws like these are prospective, which means that if the new tax laws are passed, they would most likely be in effect in January 2022. However, there is also a chance that as soon as the tax laws are signed, they could get into effect immediately.
With that said, it’s so important to act quickly if you are thinking of doing a 1031 exchange. A lot of real estate investors buy and hold property for a long time to get passive income from rent checks coming in every month and those are the people who will not be too impacted by the new tax laws immediately. However, for investors who are looking to start with a starter home and eventually sell that and move into bigger properties, the next 6 months is probably a time to be thinking about whether they want to hold that property in the long term or go out and seek another property.
2022 Proposed changes for estate inheritance taxes
Normally, what happens when someone passes away and all the assets that person owns are above a certain dollar threshold the estate pays tax on that before it gets passed on to the heirs.
Let’s say someone dies and they had accumulated real estate stocks, a business, or any amount of wealth that is over a certain dollar amount, the estate is going to have to pay tax. Right now, that amount for the estate tax is $11.7 million per person. So in the case that someone died today with $11 million of assets, the heirs can inherit it with no estate tax. That limit is set to sunset back to $5 million per person in 2025. At the moment, the inheritance tax is at 40% and there are also talks about increasing the tax rates to 45% or even having a tiered structure that gets up to 65% inheritance tax on estates over a billion dollars.
The other side of the equation when it comes to inheritance tax is what’s called step up. So in case someone dies today and they had $5,000,000 and this amount is all held up in an apartment building that was bought 20 years ago, the apartment was initially valued at $1,000,000 at the time it was initially purchased. If the person was to pass on the apartment to heirs, they would inherit a step-up basis. So their basis in that property would be $5,000,000 which is the fair market value when the person died and that theoretically means that they could turn around the next day and sell that property for $5,000,000 and not pay any federal or state taxes on that.
There’s a proposed tax law now to eliminate that step up in value. So in the above example, the heirs would inherit the property on the deceased’s basis. So in the case, the heirs wanted to sell the property, they would have to pay tax on the gain on the property. This elimination of the step-up has been proposed before and has been struck down because it’s very complex to try and track that especially in a multi-generational situation where the property moves from one person in one generation to another.
Strategies estate planning attorneys implement- Gift taxes
Right now, the estate tax and the gift tax are coupled to each other. So you get $11.7 million to give away while you are still alive or when you pass away. That may not be a bad idea if you are planning on passing on real estate property and appreciating asset if you can give them to your children now and it’s worth $2,000,000 but in 20 years from now it’s going to be worth $4,000,000, you only get dinged on your estate and gift tax limitation for $2,000,000. Part of the proposal for the change in state tax is to break that limitation and the proposal that’s being pushed now is to have a $3,500,000 estate tax but only a $1,000,000 gift tax. This means that you can only give away 1 million worth of assets when you are alive and then pass on the remaining $2,500,000 when you pass away. So breaking that can change the estate tax planning because you could give away assets now and be able to eliminate future appreciation.
The government wants to get rid of bonus depreciation by 2022
When you buy an asset, something that lasts more than a year, the government generally doesn’t allow you to immediately write off the full value of that. You have to depreciate it over time.
For example, if you buy residential real estate property that the government says has to be depreciated over 27.5 years. Commercial real estate has to be depreciated over 39 years. So bonus appreciation does not apply to actual physical real property. It applies to property that is tangible so for example vehicles, computers, furniture, and fixtures, etc. There’s something in the tax law now that’s called bonus appreciation that allows you to write off 100% of the cost of those assets. So you get an immediate deduction when you purchase those. This is only a federal deduction the state does not have an equivalent. Right now, you’re going to write off 100% of the purchase price of those assets. There’s a chain when that came into effect and it was scheduled to go gradually go away anyway. So it reduces from 100% now to 80% in 2023, 60% in 2024, 40% in 2025, 20% in 2026, and then it gets eliminated by 2027.
There is a proposal to eliminate bonus depreciation potentially starting next year so bonus depreciation is there in the tax law as a way to stimulate the economy. If you know you can go out and buy a refrigerator or a new car or upgrade your computer system and you know you are getting a 100% deduction for it, that spurs the consumer to spend money and this, in turn, stimulates the economy. This is scheduled to go away sooner than it was initially planned.
Ordinary tax rate & capital gain taxes changes for 2022
Examples of ordinary income are- wage income, business income, rental income, and interest income. Right now, the maximum ordinary income tax rate is 37% on incomes for a married couple over $600,000. The proposal on that is to restore the old tax rate and that would increase the income tax rate to 39.6% as a maximum federal tax rate on incomes over $400,000. So not only is the proposal out there to increase the tax rate, but it’s also to lower the tax bracket so it applies to more people.
Capital gains income comes into play when you have held an investable asset for more than 1 year. An investable asset is for example if you buy a stock, you own your own business and you want to sell it or a piece of property. If you hold any of these for more than a year, the gain is taxed somewhere between 0% and 20% depending on your other income items. The proposal is to change and eliminate capital gains tax rates for incomes over $1,000,000.
It’s so important now to start thinking ahead and consider what plans you have for real estate. There could be a potential for a lot of taxes on certain types of transactions that were not there before.
