The Impact of Taxing Capital Gains as Ordinary Income

In our last two posts, we addressed the potential impact of the elimination of 1031 exchanges, the last asset class to enjoy the benefits of this 100-year-old investment tool. We now move on to another plank of President Biden’s policy platform: taxing capital gains at ordinary rates, which we have grave concerns about.

Currently, capital gains at the federal level are taxed at 20%, a long-standing policy designed to encourage investment and increase the flow of capital through the economy. Another 3.8% of investment income is levied to support the Affordable Care Act, also known as Obamacare. The portion of a real estate gain attributable to depreciation taken on real estate is taxed at 25% with the remainder of the gain subject to the 20% capital gains tax rate. 

The state of California also gets it cut on the entire gain at full ordinary rates to a maximum of 13.3%. When blended together, you would pay between 34% and 37% of your entire gain in taxes to the IRS and the Franchise Tax Board. For many of you, that’s already enough to decide to hold your real estate assets and take your chances that the bull market continues.

President Biden’s proposal to tax your capital gains at ordinary rates would take the total to as high as 50% of your gain on real estate, presuming our state legislature fails in its current attempt to raise the maximum income tax bracket to 16.8%. More on that in another post. For now, we’ll stick with the current state tax code in our discussion.

So, let’s take a look at a typical 20,000-square-foot industrial building in Anaheim that was acquired for $2,400,000 ($120 per square foot) back in 2012, near the beginning of the current real estate up-cycle. That same building today is worth approximately $5,000,000 ($250 per square foot). Let’s assume a 75% building-to-land ratio for our straight line depreciation. Over 9 years, that’s adds up to $415,385 in total depreciation taken over the 9-year hold period.

After calculating and deducting your adjusted basis and the costs of selling the property in 2021, your gain would be approximately $2,765,385. Under current law, your California state income tax, assuming a 13% rate, would be $359,500. Your federal depreciation recapture tax would be $103,846 and your federal capital gains tax and Obamacare tax would be $559,300. That brings your tax burden on the sale to $1,022,646 or just under 37% of your well-deserved gain. That’s enough to convince most of you to rule out the sale of your property. Totally understandable. That’s a truly staggering number. 

However, if President Biden presses forward with his plans and House & Senate democrats vote as a block to eliminate capital gains tax rates and raise the top bracket for ordinary income to 39.6%, that number would go much higher. The federal gain portion would rise to $939,610 from $559,300. Assuming the federal depreciation recapture and state taxes stay the same, your total tax burden would rise to $1,402,946, or 50.7%! If California raises the maximum ordinary rate to 16.8%, the total tax burden would rise to 54.5%. We couldn’t think of a suitable adjective for that. 

The foregoing starts to make cashing out under current law look like a bargain by comparison, and it is something for you take seriously, especially if you have near-term plans to sell. We don’t know when the Biden administration will begin their pursuit of raising these and other taxes. At the moment, they seem to be focused elsewhere. But, that can change overnight and just the threat of these proposals will be enough to impact the psychology of decision making. 

In our next post, we will take a look at the impact of these proposals on your property’s value and marketability should they be signed into law. Stay tuned.