Elections Have Consequences: Part 2

In this second installment on the election, we focus on just a few of the Democratic challenger’s proposed tax increases that could substantially impact business and investment decision making going forward.

In Part 1 of Elections Have Consequences we discussed the shift in the psychology of decision making that precedes national elections. November 3rd is coming up fast and campaign rhetoric has reached hyperbolic proportions on a variety of issues. Even the mechanics of the election is under scrutiny as the controversy over the integrity of mail-in voting is one of the major issues of the campaign. Suffice it to say, these are unusual times and this is one of the most heated and least predictable elections of our time.

In this installment, let’s discuss the issues that would most impact commercial real estate investing. Our intent here is to focus on policy rather than politics. What follows is a snapshot of Mr. Biden’s tax proposals and our take on their potential impact on you as a business owner and investor.

The challenger’s plans have not been fully articulated in the campaign’s official website. So, we do our best here to offer our input with that limitation.

Corporate Income Taxes

A primary component of the Tax Cuts and Jobs Act of 2017 was the reduction of the corporate income tax rates from an uncompetitive 35% down to 21%. The lower rate was designed to put US tax policy more in line with other developed countries and to encourage more revenue generation inside our nation’s borders that would result in higher tax revenue for the US Treasury. The Biden plan would raise that rate back up to 28% and also establish a new alternative minimum tax of 15% for those companies who pay less than the going rate due to capital investments that reduce taxable income.

So, companies like Amazon that plow their profits into new capital expenditures and pay little in taxes as a result, would be hit hardest. We believe this would slow the growth of major corporations and reduce the volume of new property leases and acquisitions.

Mr. Biden’s plan, if passed, would also more than double the global intangible low tax income (GILTI) rate on foreign profits from 10.5% to 21%, which would further limit capital investment that creates economic growth and absorption of commercial properties.

Capital Gains

Currently, the federal long term capital gains tax rate is 20% (not including the 3.8% Obamacare tax). The current rate moved up from 15% when the so-called Bush tax cuts expired in 2013. If Mr. Biden is able to push his plan through Congress, he would essentially eliminate long term capital gain provisions for upper income taxpayers and tax gains as ordinary income instead. Even if the policy targeted just high earners, most commercial property sellers would be impacted given the massive unrealized gains they have on their properties.

Even the owner of a 10,000-square-foot industrial building acquired just 8 years ago would realize a seven-figure gain in the year of sale, which would put him a in a position where his or her tax liability on the gain would essentially double. Add California’s highest ordinary income tax rate of 13.3%, and over half a seller’s gain would be wiped out by income taxes, and that doesn’t include depreciation recapture taxes and Obamacare taxes. At the risk of revealing our feelings on this topic; that is highway robbery redefined.

The real threat of such a thing passing, we believe, would cause supply to spike and demand to decline at the same time, which would cause a major correction in property values. If it were to actually pass, supply of available properties would dwindle in the long run, as investors would be loath to sell their properties with such a draconian tax consequence. That means less capital investment and slower economic growth. Capital gains tax treatment is what it is precisely because it stimulates economic activity. So, we are having a hard time with this one, especially when it is compounded with other aspects of Biden’s plan to limit like-kind exchanges.

Like Kind Exchanges

The 1031 tax-deferred exchange strategy for commercial real estate has been around for decades. It has allowed millions of investors, large and small, to build wealth by investing in real estate. So long as all the cash from the down-leg property is reinvested and the debt is replaced with new debt or additional cash, a property owner can trade up without creating a taxable event. It is generally believed that up to 40% of commercial property transactions utilize the 1031 exchange model.

Imagine the impact on transaction volume and pricing under Mr. Biden’s plan to eliminate 1031 exchanges for high earners. It would be devastating to the commercial property markets, and that is not an exaggeration, in our opinion. Combined with the elimination of capital gains tax rates, just imagine the tax hit for those who decide to sell. Then imagine the impact on future transactions as would-be sellers refuse to sell their properties. But, that’s not all. Read on.

Step-Up Rule

Currently, the owner of a commercial property can bequeath his or her property to heirs at a basis equal to the value of the property at the time of the owner’s death. Commonly known as the step-up rule, it is the primary estate strategy for millions of investors across the nation.

Mr. Biden’s plan would eliminate the step-up rule. That much we know. What we don’t know if those inheriting the property simply inherit the adjusted basis and pay tax when the heirs sell, or if the gain would be taxed at the time of death, which in most instances would force the immediate sale of the property. The consequences of that are too complex to cover in this post, but imagine being forced to sell a property in a down market just to meet a tax obligation. Among other things (none of them good) it would be a disaster.

The elimination of the step-up rule would send millions of investors back to their estate planners who won’t have much to offer their clients other than bad news. For investors with larger portfolios, it gets even worse. Read on.

Estate Tax Threshold

Currently, an individual estate is subject to a 40% estate tax, (aka a Death Tax) on net estate value over approximately $11.8 million, double that for joint estates. The Biden plan would reduce the threshold to around $5 million for an individual estate. It is unclear to us from our research what the joint estate threshold would be. If new thresholds were imposed, it would be another reason to completely alter the exit strategy for high net worth individuals, family trusts, etc.

That would be good for estate and tax lawyers, but bad for pretty much everybody else. Many properties would have to be liquidated just to meet the tax consequences of an investor’s death. There is something inherently wrong with that in our view. Investors take risks and work hard to acquire portfolios of performing assets. To have their efforts end in tax-induced liquidation no matter what the market conditions, seems wrong on many levels.

Marginal Income Tax Rates

The Biden plan would return the top marginal income tax rate to 39.6% from 37%, cap itemized deductions and restart the 12.4% payroll tax for Social Security once a taxpayer’s wage income hits $400,000. The plan would also eliminate the 20% income exemption for pass-through entities, effectively raising taxes on S-Corps, LLC’s and similar entities. And, don’t forget these increases would further exacerbate the impact of the elimination of capital gains tax rates, a true double-whammy for those who have been successful through their hard work and savvy decision making.

The more we look into the Biden platform, the more we grow concerned about its likely impact on commercial real estate. To be sure, the situation is fluid and we are short on detail at this point in the game. As we learn more, we will share our findings with you. If you have any questions, just give us a call. We are always here to help.