President Biden unveiled a $3.6 trillion tax plan earlier this year that could have significant tax implications for real estate investors, inheritors, and married couples making $509,300 or more a year, or single individuals making $452,700 or more a year.
The plan still needs to be approved by Congress and has already received significant pushback from Republicans and some moderate Democrats. But if it does go through as proposed, here’s how real estate sales would be impacted.
Real Estate Inheritors Could Owe Higher Capital Gains Tax
The proposed tax plan would eliminate the step-up in basis provision, which currently adjusts the value of an inherited asset, like real estate, when it is passed on after the original owner’s death. The new tax proposal would prevent individuals from avoiding capital gains tax when selling inherited real estate that has gains exceeding $1 million (or $2.5 million for married couples). Instead, the inherited property will be assessed at market value and the inheritor would be liable for capital gains tax at that new tax base.
Here’s how that might look: Under current law, if you inherited a townhome in Cupertino from your mother that is now worth $1.6 million —at the time of your mother’s death — but was purchased in 2005 for $500,000, you would not have to pay capital gains tax if you sold the property at the $1.6 million price. But under the proposed tax plan, if you were to sell the Cupertino townhome after inheriting it, your gain would be $1.1 million, so you would be subject to capital gains tax on the excess $100,000.
Exceptions to the rule are family-owned businesses, so long as the heirs continue to run the business, as well as properties donated to charity. But for children expecting to inherit and sell expensive property from their parents or other relatives, a potential elimination of the step-up in basis provision could be significant.
1031 Exchange Limits for Real Estate Investors
Real estate investors can currently use 1031 exchanges to defer capital gains tax if they exchange one investment property for another of equal or higher value, with capital gains tax only being due when an investor finally sells an investment property for cash.
Under the new tax proposal, investors may only defer capital gains tax up to $500,000 for individuals or $1 million for married couples filing a joint return for like-kind exchanges. Investors would then be subject to capital gains tax on any profit above the $500,000 or $1 million threshold.
For example, if you originally purchased a property for $500,000 that is now worth $1.5 million, you will be subject to capital gains tax on the
$500,000 that exceeds the threshold, even if you wanted to invest that profit into another investment property.
Long-Term Capital Gains Tax Increases for Top Earners
Capital gains for those making $1 million or more a year would be taxed as ordinary income under the proposed tax plan, meaning that top earners would be subject to a 39.6% tax rate — up from 20% for that income bracket.
There’s no reason to fret just yet, given that the plan will likely undergo some changes as Congress reviews the tax plan, but it’s always good to be prepared.