In the last blog article, we discussed the devastating effects that eliminating or dramatically decreasing the benefits of a 1031 will have on selling rural properties. Next, we are going to talk about 3 other proposed tax change laws but before we do, I need to mention one last thing about 1031s. Something that is not finalized yet but could be a major problem for property owners is simply how often will someone be able to transact a 1031. If Congress decides to limit the benefits of a 1031 to a maximum of 500k, will that be per transaction or per taxpayer. The smart money is on per taxpayer. Either way that can be devastating and do not forget that deals with capital gains. What about state tax, depreciation recapture and the Medicare tax? Our Section 453 proprietary trust can defer all those taxes but let us move on to the 3 other major changes.
I had the privilege to speak at a seminar recently on this topic and the speaker before me said that the next endangered species in this is country is the landowner. Was he right! The other proposed tax law changes are (1) the elimination of the stepped-up basis, (2) the doubling of the capital gains tax to 39.6%, (3) the reduction of the federal estate tax exemption to $3.5 million and an increase of the federal estate tax rate to 45%. Every one of these proposed tax law changes can cause potential needless tax burdens on property owners.
Let us start with the elimination of the stepped-up basis. Most landowners may not be aware of how important this is. In a typical situation today, a parent can buy a property, keep it his entire life and when he passes on, the property can be inherited by the children, and they receive a new “basis” on the property. Here is what that means. Say the parents bought a property for $100k and when they passed the property on to their children, let us say that the new basis is $1 million. Soon after the children receive the property, they sell it for $1.1 million. They have a gain of $100k and they pay the capital gains tax, state tax where applicable, depreciation recapture and the Medicare taxes on their gain.
Biden does not like that because he wants more taxes so by eliminating the stepped-up basis, when the children inherit the property, their basis is $100k which is the same as their parents and now when they sell the property for $1.1 million, their capital gain is not $100k but $1 million and they pay the taxes on the million-dollar gain. That’s sad but that could be one of the proposed tax law changes.
One of the most talked about proposed tax law changes is the doubling of the capital gains tax to 39.6%. In the interest of full disclosure, much of the regulations regarding this increase are still up in the air but let us talk about what we think will happen so we can be prepared in case these changes happen. The main comment that is being made is that you will not pay the 39.6% capital gains tax unless you have family income of at least $1 million. That sounds great until you start digging. Good thing that I am here. Right? Lol What exactly does income mean? As of now it means all income not just earned income. If that happens, consider this simple scenario. A farmer is in the fields before sun rise and does not get home until the sun is halfway to China. He makes $50k a year and after working the family farm for the past 50 years, he wants to sell and retire and enjoy the rest of his life. Because his family has owned the farm for so long, the basis is probably minimal so it is possible that 90+% of the sales proceeds will be capital gains. Those capital gains will almost certainly put his income over the $1 million threshold so he gets to pay 39.6% in capital gains and if he is fortunate to live in a high taxed state, his total tax liability can be over 50% in taxes on the gains of his sales proceeds. Thanks Joe.
The third proposed tax law changes could possibly be the worst of all but is getting minimal attention and that are the changes in the federal estate tax. Currently, most landowners are protected by what is called the federal estate tax exemption. That is basically the amount of property the spouses can own before they qualify for the federal estate tax and quite honestly those that have more assets than their federal estate tax exemptions probably have sophisticated advisors to help them avoid or minimize their federal estate tax burden. The average family may not have access to that sophisticated planning and because the federal estate tax exemption is proposed to be lowered to $3.5 million per spouse, now that family may have a taxable estate at a 45% tax rate and may have sell their property in order to pay a large amount of taxes. Thanks again Joe.
These proposed tax law changes and the elimination of 1031s as we mentioned in the past will have a chilling effect on all real estate. That is the bad news. But again, there is good news. I am not going to scare you unless I have a great solution to these proposed changes and of course, I do. Think of me as John Wayne and the 7th Calvary riding to the rescue. Well, close. As I previously mentioned, our Section 453 proprietary trust is a better option today than a 1031 so if 1031s are eliminated or the benefits are dramatically reduced, we are still here providing a better opportunity to defer taxes as we have for the last 25+ years. Let us start with the elimination of the stepped-up basis.
The stepped- up basis is not an issue with our trust because the property is already sold, taxes deferred and the seller gets a zero-interest free loan from Uncle Sam for as long as he would like and when he passes on, the trust assets may be able to be passed on to the heirs out of the estate. Our trust is a much better opportunity for the heirs than dealing with the loss of the stepped-up basis.
Next up is the capital gains tax. Nothing is set in stone yet but here is what we need to be prepared for. First, Biden wants the capital gains tax rate retroactive back to April 2021 so if you have not sold yet, you pay the 39.6% capital gains tax. That is criminal but could happen. But it could get even worse. Say you make 100k a year and sell a great property that creates a $1.25 million capital gain. Congrats! You are over the $1 million threshold because family income currently means all income so your income in that year is $1.35 million. Great news, right? Hopefully, that will not be part of the final deal. Just be prepared. The good news is that our Section 453 proprietary trust can not only defer the taxes when sold but will not be affected by the capital gains being retroactive to April 2021. We have you covered.
Finally, the last major change is the reduction of the federal estate tax exemption to $3.5 million and an increase in the tax rate to 45%. I am told there may be a cutout for farms and ranches and I hope that happens, but I am not holding my breath. The bottom line is that after paying taxes your entire life, Uncle Sam still wants one more shot at your paying taxes when you pass on hopefully to somewhere with less taxes. Again, the bottom line is when selling using our proprietary trust, we can take the asset when sold out of the estate to potentially reduce the family’s federal estate tax burden.
It can not be emphasized enough that nothing is final, but it is important to be prepared should these tax law changes occur. I may not be John Wayne but maybe it is my time to come to your rescue and keep more of your hard-earned proceeds in your pocket and less going to Washington DC. Happy Selling!
by David Fisher
David Fisher is the founding partner for Creative Real Estate Strategies, a firm dedicated to helping their clients buy and sell real estate in the most tax efficient manner through cost segregation, tax credits or deferring taxes through our Section 453 proprietary program.
David can be reached at his email address david@cresknowsrealestate.com, mobile 713-702-6401 or his website www.cresknowsrealestate.com
