As we enter the Biden Presidency in 2021 investors should be prepared for new taxes. The details will be negotiated in Congress, but expect these taxes to affect real estate investing including capital gains. There will also be new taxes to shore up the solvency of Social Security. Some of this will depend on whether the Republicans retain control of the Senate after the two runoff elections in Georgia on January 5. I remain apolitical, but if the Democrats have the White House and both houses of Congress they will have freer reign on to make these changes.
We can already see a few themes emerging which include more taxes on individuals earning $400,000 or more, and using the tax code to make housing more affordable. Also expect the next administration to create incentives for lower to middle income workers to save more in retirement vehicles like 401(k)s and Individuals Retirement Accounts (IRAs). Click here for detailed explanations of 401(k) accounts and IRAs.
$400,000 is the Magic Number
The Biden tax plan appears focused on adding most of these new taxes on individuals earning $400,000 or more. This includes increasing the individual income tax rate on income over $400,000 from 37% to 39.6%. Also for those with incomes above $400,000, his team is proposing capping itemized deductions to 28%, instead of the taxpayer's applicable tax bracket. This limits the ability to deduct expenses. For example, if you are in the new 39.6% tax bracket and had an expense of $1,000 you would normally take a deduction of $396 for this expense. Under the new plan your exemption is capped at 28%, so you can only deduct $280 for this $1,000 expense. This means losing $116 per $1,000 of eligible deductions. The Biden plan also looks to phase out qualified business income deduction (Section 199A) for those with income above $400,000. This would also increase the tax obligation for those making $400,000 or more a year.
Tax Changes for Social Security
To strengthen the Social Security program the Biden administration is looking to add new taxes on individuals earning, you guessed it, $400,000 or more. In chapter 17 of Become Loaded for Life I explained how Social Security Retirement Benefits are severely underfunded. I also predicted that payroll taxes will apply to more of a person's income in order to pay for future benefits.
Currently, the tax rate for funding Social Security Retirement Benefits is 6.2% paid by the employer and 6.2% paid by the employee for a total rate of 12.4%. But, this tax only applies to the first $137,700 in wage income earned. To shore up Social Security, the Biden team is proposing this 12.4% Social Security payroll tax, split evenly between employer and employee, will apply to wages above $400,000. So earners will pay the tax on income up to $137,700 then get a break on the tax until their income reaches $400,000 and then the tax will kick in again. This will address some of the challenges facing the solvency of Social Security, but not all. As discussed in chapter 17, there are other changes that are needed to protect future Social Security Retirement Benefits.
Capital Gains Are Going Up
Other tax options on the table are increasing the corporate tax rate from 21% to 28% and raising the tax on long-term capital gains and qualified dividends above $1 million to 39.6%. Currently, the long term rate is 20% so this is a significant increase for high earners, as their tax on capital gains and dividends will be the same rate as ordinary income. If you are in this category you might want to do some selling of assets before December 31, 2020. For example, on a capital gain of $100,000 you will pay $20,000 in taxes before the end of the year but $39,600 in taxes on January 1. Shelling out $19,600 more in taxes is a whole lot of cheddar for the difference of one day.
Tax Changes for Retirement Accounts
To assist lower income and middle income workers, the Biden team is expected to make changes to retirement accounts like 401(k)s by offering more tax credits for saving. These accounts offer an unintended benefit to higher paid workers. For example, if you save $10,000 in your 401(k) account and are in the 12% tax bracket you have saved $1,200 in taxes. But if you are a higher earner in the 24% tax bracket that same $10,000 contribution would save you $2,400 in taxes. One worker saves 12 cents on the dollar while the other saves 24 cents. The Biden team will probably address this disparity by offering tax credits to lower income savers. There are also proposals to encourage small business owners to implement retirement savings plans for their employees so more workers are covered by these retirement plans.
Just as the government giveth, it also taketh away. The other way the Biden team could address this disparity is to phase out some of the tax deductions for 401(k) contributions. This would encourage higher income workers to channel more retirement savings into non-tax deductible retirement accounts like a Roth 401(k) or Roth IRA. With these accounts, contributions are taxed before they go in which provides the government with more tax revenue. In return Uncle Sam promises not to tax your withdrawals from these accounts in retirement. But as we all know tax laws can change. The United States currently has a national deficient that exceeds $27 trillion and it has added more than $3 trillion in 2020 due to pandemic related stimulus spending. This debt eventually has to be repaid so the government will be looking for income to tax and there is no guarantee Roth withdrawals will remain tax free forever. See here for a more detailed analysis of the risk posed by the U.S debt.
Real Estate Taxes: Affordable Housing Focus
During the Global Financial Crisis (GFC) in 2007-08, real estate prices fell dramatically and many home buyers were reluctant to buy houses. The U.S. government mopped up some of this excessive supply of homes by incentivizing buyers with a First-Time Homebuyers’ Tax Credit. In 2021 the Biden Presidency will look to reintroduce a similar $15,000 homebuyers' credit. Although this time the problem is not a supply of too many houses it is that there are too few and home prices have risen dramatically since the GFC. This time the Homebuyer credit would be used to make housing more affordable by giving a tax break to lower income buyers.
Although it sounds good in practice, what often happens with these types of tax incentives is sellers are wise to them, and if the market allows, seller just raise the price of their homes. This in turn leads to the same problem, as homes are once again just out of reach for many buyers. Another strategy being considered by the Biden team to make housing more affordable is through a Federal renter’s tax credit program. According to the Center on Budget and Policy Priorities this would provide up to $5 billion in annual Federal tax credits which are passed on to property owners. The program is expected to reduce rent by $400 for up to 1.2 million lower income families.
Separately, the Biden team is also looking to increase the amounts offered under the Low-Income Housing Tax Credit. This is a dollar-for-dollar tax credit used to encourage real estate investors to construct or rehabilitate affordable housing for low income tenants. In particular it would help real estate investors who participate in syndication or partnerships that invest in this type of real estate.
More Taxes May Discourage Real Estate Sellers
There are other factors that are likely to have an impact on real estate investors and the broader real estate market. The increase in capital gains mentioned above will likely discourage some real estate investors from selling investment properties to avoid these higher taxes. Also worrying for real estate investors are rumors that Biden’s team is interested in eliminating the 1031 Like-Kind exchanges for higher income earners. For the uninitiated, 1031 exchanges allow real estate investors to defer paying capital gains on the sale of a property as long as they purchase a similar but more expensive property with the proceeds of the sale within a specified time.
The 1031 exchange is an important tool in rolling over your capital gains tax free into larger properties. Without a 1031 exchange investors would be required to pay the capital gains on each sale and they may prefer to hold properties instead of selling. This could reduce the number of properties coming on the market unless we see more activity in the construction sector to increase supply.
Foreclosures and Evictions: Pandemic Risks Remain for Real Estate Investors
Despite positive reports of vaccine trials, we are not out of the COVID-19 woods yet. Real estate investors need to keep a close eye on foreclosures, evictions and the volume of unpaid rent as we head into 2021. When the virus hit in early 2020 unemployment rose quickly to 14.7 percent in April 2020. These job losses made it difficult for some tenants to pay rent, and in response cities and states issued a moratorium on evictions if tenants failed to pay rent. Although some of those provisions lapsed, the Centers for Disease Control and Prevention stepped in to impose restrictions on evicting tenants for nonpayment of rent through December 31, 2020. This led some mortgage holders to take advantage of forbearance programs under the CARES Act which created a moratorium on foreclosures and offered forbearance options for borrowers who could not make their loan payments. The Biden administration will need to address these issues early in 2021 to provide more clarity to real estate investors and tenants. One option may be a tax break for landlords who are not receiving rents or rent support for those tenants facing eviction. (Update: One of President Biden's first executive orders was to extend the eviction moratorium to March 31, 2021). For more on this topic see Unpaid Rent: Worrying Signs from the COVID-19 Recession and How to Protect Yourself and also in Seven Ways to Prevent Unpaid Rent.
There will be more to watch for on tax reforms in the coming weeks. But as 2020 draws to a close look for ways to make wise tax planning decisions and consult a tax professional if needed before some of these new taxes take effect in 2021.
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