In the $1.8 trillion American Families Plan, Joe Biden is looking at tightening up the tax code to move more funding into families and education. What tax provisions could be changed?
- The 1031 exchange (like-kind exchange) tax-deferrals for business or rental properties.
- The stepped-up cost basis for heirs after the homeowner dies.
- The current estate tax exemption.
- Gift tax provisions.
Congress would have to approve any changes, so none of these will be enacted immediately. If and when they are enacted, their bite may be less than their bark. Let’s take a look.
Like-Kind Properties: What Could Change for Section 1031?
Real estate investors upgrade their holdings to higher-priced properties from time to time. Selling one property to buy another typically involves capital gains tax on the first one. But Section 1031 of the Internal Revenue Code enables tax deferral. This can empower the investor to focus on putting money down on the best property to replace the one that’s just been sold. Spoiler alert: Section 1031 is likely here to stay. Assuming it can overcome real estate industry opposition, many people with rental properties will not be impacted much if at all, and any changes may only be applicable to exchanges in 2022 and later.
☛ How is a 1031 exchange done? See more details at For Property Investors: Six Steps to a 1031 Exchange on Deeds.com.
Section 1031’s proponents say the provision is used by small business and farm owners. They point out that it helps investors make increasingly more productive use of real estate. Here’s how:
On behalf of these investors, intermediaries hold the sale profits in escrow until the new purchase closes (by law, within 180 days from the sale of the previously owned property). While the qualified intermediary uses the proceeds from the sale of a client’s prior property to buy the new property, it’s the client who receives the deed. Because the investor technically doesn’t touch the capital gains, no tax event occurs. Investors can enjoy unlimited chains of investment growth and tax deferral. By adhering to IRS rules, they benefit from the tax savings for life, by ultimately converting the final property to a primary residence, or passing it after death as a tenancy in common for their beneficiaries.
Pro tip 1: The tax code limits capital gains tax exposure when the owner is ready to sell the property — if it was the owner’s primary residence for at least two years within the five years leading up to selling. Restrictions (involving the government’s recapture of building depreciation, and the balance of time the property was in qualified and nonqualified use) apply to tax exclusions, so speak with your tax adviser when planning to sell.
Pro tip 2: Holding onto your exchange property for life? Your heirs should understand the most tax-efficient timing for selling an inherited home in the future. Consult an estates and trusts lawyer, or a tax expert experienced with Section 1031 exchanges, to examine your own situation and advise you.
Joe Biden has been proposing changes to Section 1031 for some time — even before becoming president. But that doesn’t mean the changes will happen.
May 2021 budget documents released by the administration suggests a cap on deferrable capital gains to $500,000 annually per person ($1 million per married couple). That suggests that property owners expecting at least $500,000 in profit would be especially well advised to consult their financial experts and plan for possible adjustments.
If more impactful changes occur, we’ll keep our readers posted.
Death and Taxes: What’s Happening to the Estate Tax and the Stepped-Up Cost Basis?
As of the 2021 tax year, most people die without triggering estate tax. No one owes estate tax whose estate is worth less than $11.7 million (double that for couples).
The Biden administration has proposed taxing estates of around $5 million per person, which could broaden the net significantly — but this would still only present a tax question for people who pass away with millions of dollars in assets. We’ll be watching to see how this proposal plays out.
We should note here that even a modestly valued home could be subject to federal or state estate tax depending on how many assets you leave upon death. Note that state governments may set lower thresholds for values of taxable estates.
The stepped-up cost basis for people inheriting homes could impact many more people.
Today, many homeowners keep houses they’ve had for years or decades, holding them as they build equity, eventually passing them along to heirs. Bequeathing a home to heirs (rather than giving it or selling it) can spare families from paying taxes on capital gains that accrued over the course of their homeownership.
To consider a common scenario, say you buy a $150,000 condo. That’s your cost basis. Sell it for $250,000 in 2025, and you’ll owe taxes on your $100,000 in sale profits (capital gains). If you don’t sell, but leave the home to your heirs, the condo’s cost basis is “stepped up” to whatever its value is when you pass away. So, your own increase of property value over the years can bypass capital gains tax when you pass on. The beneficiaries of your will do not have to come up with capital gains on your increase in value at the time of inheritance.
During Biden’s administration, the rules could change. We’ll be watching this. Ending the stepped-up tax basis for heirs could affect even families of modest means who have held their homes through a long period of property value appreciation.
Moving Forward: Why Expert Tax Help Matters
Capital gains taxation is complicated. So are the decisions a homeowner makes between gifting a home, placing it into a trust such as a qualified personal residence trust (QPRT), passing it along through a will, or using other instruments such as the transfer on death deed.
☛ Learn more about Estate Planning for Your Real Property from Deeds.com.
As you plan at the intersection of tax and your real estate holdings, tax and legal adviser can advise you on strategies that tend to perform well in a variety of policy frameworks. Advice that suits another household may not be right for you. Case-specific advice matters, so be sure to ask your own expert if you have questions on current tax policies and changes.
We’re confident about real estate and the value it brings buyers over time. Carefully chosen properties can do very well for the purposes of income and appreciation. Overall, while building wealth through real estate appreciation can’t be guaranteed, its value transcends policy changes from one administration to the next.
Supporting References
26 U.S. Code § 1031: Exchange of Real Property Held for Productive Use or Investment.
Internal Revenue Code § 1014 (a): Basis of Property Acquired From a Decedent.
Internal Revenue Code § 121(a), § 121(d)(6): Exclusion of Gain From Sale of Principal Residence.
IRS Fact Sheet on Section 1031 of the U.S. Internal Revenue Code.
Robert Bloink and William H. Byrnes for ThinkAdvisor.com (sponsored by Vanguard): Biden’s Estate Tax Overhaul: Forewarned Is Forearmed (Jun 16, 2021).
Dwight Kay for Kiplinger: How Biden’s Tax Plan Could Affect Your Real Estate Investments (Jun. 22, 2021).
Elder Law Answers: Biden Administration May Spell Changes to Estate Tax and Stepped-Up Basis Rule (Apr. 29, 2021).
Photo credits: René DeAnda and Jon Tyson, via Unsplash.