As we’ve passed mid-year 2021, the post-Covid world is showing more than a glimmer of possibility that the world is returning to some form of normal! Economists, politicians, and commercial real estate investors alike are all beginning to direct their attention to stabilizing investment markets (see our Spring post, Stability is Around the Corner).
In the last several months, apartment occupancy stabilized, concessions mostly burned-off, and rental rates began a march upwards to pre-pandemic levels. Less than a year ago the world seemed to stare-down a financial Armageddon, yet spring showers bloomed nascent signs of a repaired(ing) apartment market in the Pacific Northwest.
Let’s not do that again!
Just as one near disaster is averted, commercial real estate investors must turn their collective attention to changes – actual and proposed – in Washington State and federal taxation.
The New Biden Green Book proposes sweeping changes in tax law, and for Washingtonians, those proposals are coupled with already in-place changes in Washington State taxation on capital gains.
What additional changes and proposals are in federal and state crosshairs:
- Changes in marginal income tax rates
- Changes in capital gains taxation & carried interest
- Changes in transfer taxation (stepped-up basis / inheritance)
- And a laundry list of et ceteras …
The headlines tell a blurry story around clear concerns about President Joe Biden’s tax overhaul, dubbed the ‘Green Book’, which includes changes in capital gains rates and inheritance taxes.
Capital gains tax rates could rise to a whopping 37% for the highest earners (up from 20%) which would be in addition to any local and state taxes. Luckily when it comes to real estate capital gains, sellers are in the clear this time.
Beyond this potentially significant impact to High Net Worth (HNW) individuals, another concern looms with eliminating the “step-up in basis” in heritance of assets at death; adding injury to, well, injury, many states are proposing or legislating changes to inheritance or estate taxes also (you read that right, a federal estate tax and a state level tax).
Each individual beneficiary or heir of an estate is subject to inheritance tax based on their income, whereas an estate tax is levied on the decedent’s estate entity. Currently the federal government has only a formal estate tax; the same is true for Washington. Washington is among only 17 states that have some form of wealth tax at death, either estate or inheritance.
Capital Gains Taxation in Washington State
In Washington State, effective January 1, 2022, state residents and nonresidents who sell tangible personal property in Washington will be subject to a new 7% capital gains tax on long-term gains exceeding a $250,000 annual threshold (H.B. 1496). The tax is applicable to individuals, not business entities.
The good news is that real estate is an exempt asset class from the new tax law.
So, who does this new state capital gains tax impact? According to the State, under one quarter of one percent of the population. Opposition of the bill points out that the tax is unnecessary, as Governor Jay Inslee estimates the state’s budget reserves are around $1B through 2023.
Proponents, however, argue that the capital gains tax measure is structured as an excise tax and would withstand scrutiny; the same proponents make claims that the state has one of the most regressive tax systems (Washington tax regime remains largely unchanged since the 1930s).
Federal Capital Gains Taxation
Since real estate gains taxation isn’t a concern at the moment in Washington, let’s get back to the federal government plan. The capital gains tax rate of 37% mentioned previously (and as high as 40.81% for some!) may be realized for HNW individuals particularly when completing a 1031 exchange. The Green Book would limit the amount of deferred capital gains in a 1031 like-kind exchange to $500K, or $1MM for a married couple filing jointly.
This means any gains realized over $500K per individual would be taxed as income at the above mentioned proposed new higher rate2. Those in favor of maintaining the status quo around like-kind exchange benefits make a case that the system encourages reinvestment and is more accessible to a range of investors, not just HNW ones, and therefore allows an opportunity to close the nation’s wealth gap, which is one the Green Book’s broad concerns.
This may be daunting to consider for those HNW individuals. However, the key take away here for most isn’t necessarily what the headlines have been touting—it isn’t capital gains, its planning for the future.
Planning for Changes in the Near Future
Investors who aren’t already considering taking immediate action should take a look at succession planning, including possibly a sale of shorter-term real estate holdings into a truly long-term real estate assets with a succession plan.
The Center on Budget and Policy Priorities currently recommends that states that don’t already have one, adopt some form of wealth tax at death. In addition to rolling back business tax changes that were introduced with 2017’s Tax Cuts and Jobs Act, this is what the federal government is moving towards as a way of moving wealth after death—to introduce or increase wealth taxes on estates.
While many investors may be familiar with utilizing various forms of trusts for estate planning purposes, many may not be aware of tax penalties associated with them. According to attorneys, there are other common errors made with estate planning, such as not properly funding trusts with assets, or not updating asset ownership from time to time to match the current needs and goals of the estate.
Another pitfall that occurs in estate planning, is not coordinating trusts and retirement plans properly; but what some investors may not consider, is how to utilize 401K or IRA retirement plan to invest in real estate assets, thus optimizing your tax benefits.
This may be fairly easily accomplished through one’s retirement account provider, but to fully understand the tax implications, including benefits and costs, one should consultant their accountant or tax preparer. If you need help, we can refer you to the best resource!
But just what is the need for these tax increases in the first place? Surely this can’t be just a pendulum swing from the slashes of the Tax Cuts and Jobs Act. Well, it isn’t. As an article in The Economist last week zeroes in, there’s around $61B that could be elicited from enforcing the current tax code over the next ten years, while costing $21B in enforcement by the IRS.
The amount earned put back into enforcement would yield more than double the result in the following time period, and without changing any of the current tax code—although there’s still plenty of room for that. While tax increases are one route to the government curing budget deficits, another option exists in properly funding the IRS and capturing taxes accordingly without any changes whatsoever.
At the end of the day, whether red or blue, right or left, just how taxes are collected may be just as important as how much. Stay tuned for further updates!
As you plan for changes in tax laws – and your future – allow us to be a resource to you.
Whether we are providing a free valuation of your apartment building, or discussing strategies for a sale, Let us Turn our Expertise into Your Profit!
You can read Biden’s “Green Book” online here in full.
1 For those whose annual income exceeds $1 million
2 General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals (‘Green Book’), page 90