Since the new administration took the reins back in January, we have closely followed what was originally dubbed the American Families Plan, a massive social spending proposal that included several potential tax hikes that would impact commercial real estate markets across the country.
In its original form, the American Families Plan laid out by the White House, called for capital gains to be taxed at ordinary income tax rates, severe limitations on 1031 exchanges and the taxing of unrealized capital gains at death, which would have eliminated the step-up rule, a widely used wealth transfer mechanism.
To say that we were worried about the ramifications of any one of these possible changes, is an understatement at best. To think of all of them becoming law was downright terrifying. So, we sounded the alarm and encouraged all of you to re-evaluate your investment strategies and consider the possibility of a market correction as a clear and present danger.
Fast forward to today, and things are beginning to look different—in a good way. In September, the House Ways & Means committee (where all revenue-raising legislation originates) came out with its recommendations for tax increases associated with the American Families Plan. We were surprised and pleased that the committee proposed a more modest increase in the capital gains tax rate (from 20% to 25%), made no mention of changing 1031 exchange rules and left the step-up rule in place. However, the committee did recommend a substantial reduction in the estate tax exemption (from $11.7 million to $5 million for individual estates), along with the elimination of certain types of trusts used to reduce the taxable value of estates.
Since Ways & Means made its proposal, we’ve been waiting for the Senate Finance & Budget committees to weigh in, but all we’ve heard is crickets. Intra-party disagreement and other pressing issues seemed to have pushed tax increases off the front pages, especially the recent spike in inflation, which is now running more than double the Fed’s target of 2%. The argument now is whether or not that increase is transitory or not. If not, the Fed will have to tighten its grip by increasing interest rates, which would certainly erode the borrowing power of those looking to acquire commercial real estate. And, since the low cost of capital has been a primary driver of property appreciation throughout this real estate up-cycle, many real estate experts are genuinely concerned over a possible correction if inflation persists at elevated levels.
What does all this mean to you as an owner of commercial real estate? That depends on your investment timeline. If your property is performing well and you have no plans to exit your investment in the next 5 years, it may not mean much at all. But, if your strategy calls for a disposition within that time frame, it may be a clear signal to head for the exits. Demand for industrial property is at an all-time high, and other than in the Inland Empire, construction of new inventory is at an all-time low. So, current owners are and will remain in the driver’s seat until there is a substantial shock to the demand side of the equation. Our experience tells us that can happen quickly when a substantial economic shock occurs, but no one can predict exactly what that shock will be, if there is one at all, or how significant it will be if it does occur.
As it relates to the American Families Plan, now renamed the Build Back Better Act, it’s hard for us to believe that so much political capital will be spent with nothing to show for it. So, it’s probably wise to factor the tax increases, as proposed by the House Ways & Means committee, into your strategic re-evaluation. If you come to the conclusion that disposing of commercial real estate under today’s rules is best, there is still just enough time to take action and complete a sale before the rules change. If you decide that the tax increases, as proposed, do not pose a serious threat to your property’s value, then it may make sense to maintain your long-term strategy.
At this point, it is not a foregone conclusion that taxes will go up, just a distinct possibility. The political wrangling going on in Washington, DC is opaque and clarity on the issue could be weeks or even months away. The key is to be prepared for all possible outcomes. So, if you’d like to learn more about your property’s value and position in the market, just give us a call. We are here to help.