Is the Step-Up Rule in Jeopardy?

In this post, we take a look at another of President Biden’s campaign planks; the elimination of the step-up rule, an estate planning tool widely used by investors large and small for decades.

Candidate Joe Biden ran for President on a platform of tax-code changes, several of which could have substantial impact on real property investing.

In the past few weeks, we have been discussing the potential loss of 1031 tax-deferred exchanges and the taxing of capital gains as ordinary income. Either one of these possible changes pose a threat to property values, but together they are even more of a concern to us.

Today – a look at the proposed elimination of the step-up rule.

The step-up rule allows the holder of stocks, bonds, real estate and other assets to pass those assets to their heirs upon death at a step up in basis to current market value. If they choose to do so, heirs can then immediately liquidate those assets without precipitating a taxable event.

Sound like a pretty good deal? It is, and opponents of the step-up rule single it out as a massive tax-loophole. Whether it is or it isn’t, it is a completely legal way for you as an investor to pass along your wealth to loved ones to enjoy. And, there’s a good chance that most of you who are reading this post have adopted this end-of-life strategy for yourselves.

As many of you know, there is a chronic shortage of industrial supply, both from an owner/user and third-party investor standpoint. Vacancy throughout Southern California is at all-time low with demand far out-pacing supply for industrial properties. The step-up rule is a major contributor to that shortage. Property owners of highly appreciated assets who do not have a pressing need to liquidate assets, tend to hold them to avoid high capital gains and depreciation recapture taxes. Instead, they tend to hold them for steady cash flow and pass them along to their heirs when their days are over. 

This is an investment strategy that is time-tested and one that we hear articulated by our clients every day. They just can’t accept the idea of giving up more than a third of their hard-earned gains to state and federal taxes knowing that those taxes could be ultimately avoided. Thus, they adopt a ‘swap ‘til you drop strategy’ as a prudent tax strategy rather than realize gains, pay taxes and end up with a pile of cash in the bank to ultimately distribute to heirs. Makes perfect sense to us and it makes perfect sense to literally millions of commercial property owners all across the country.

So, if the step-up rule was eliminated, what would the impact on the real estate market be? To be sure, many investors would likely have a change of heart in terms of their investment strategy. Input we get from our clients tells us that many of them are holding onto assets specifically because of the step-up rule. So, without it, many of them would decide to sell real estate portfolios to reduce their risk, eliminate the complexities of property and asset management, and maybe even distribute portions of their estates while they are still alive. 

This would most certainly result in more available supply, recalibrating the current supply/demand balance. If supply got ahead of demand, property values would decline. If that occurred, demand would eventually decline, as well, because real estate as an asset class would be perceived as carrying more risk. More risk means a higher risk premium would be applied in the underwriting process. Cap rates would have to rise, which means lower prices.

After an initial surge in supply and resulting correction, holding periods would likely be extended, as heirs to property portfolios would have inherited the tax basis of the original investor. So, the tax tail will be wagging the dog even more than it already is today. Transaction activity would decline, resulting in fewer taxable sales. Fewer taxable events means lower tax collections, the unintended consequence and opposite result of changing the step-up rule in the first place. This makes little sense to us.

If your investment strategy is built all or in part on the step-up rule, this is the time to consult with your financial advisors to discuss a course correction. Though none of the new administration’s tax proposals have made their way into the headlines yet, just the threat of big changes like eliminating the step-up rule could impact market dynamics. Those who wait until the tax code actually changes may be late to the party and find themselves competing against other investors who did the same. It never hurts to be prepared and the nominal cost in time and money of reviewing your own strategy would be well worth the effort.