As 2021 draws to a close, many commercial real estate investors are looking to sell. One large reason for the influx in property sales is the projected increase in capital gains taxes for 2022. As of now, the tax law changes are uncertain. Nonetheless, many sellers are looking to secure a sale before 2022 because of the possibility that any sale following 2022 could fall into a new tax bracket.
Under the 1031 exchange, investors can defer paying capital gains taxes on their property if they also purchase a similar property shortly after. However, President Biden has proposed new restrictions on the 1031 exchange that would end the real estate tax break and require sellers to pay capital gains taxes on gains over $500,000. The goal is to raise $1.8 trillion for the American Families Plan.
“The government wants to continue to feed social spending programs,” said Paul Getty, CEO of First Guardian Group. “If you look around the world, a lot of countries have higher capital gains taxes.”
Getty added, “So I think when politicians look broadly on how to raise taxes, there’s some appeal to raising capital gains to levels that are maybe more commensurate with other industrial nations around the world. But fundamentally, the reason they’re raising taxes is because they want to increase social spending.”
Biden’s proposed plan, according to the White House Briefing Room, “will eliminate long-standing [tax] loopholes, including lower taxes on capital gains.” Currently, “the tax rate the wealthy pay on capital gains and dividends is less than the tax rate that many middle-class families pay on their wages.”
Getty said, “A 1031 exchange is probably the greatest — I wouldn’t call it a loophole — but the greatest tax benefit that’s conferred on real estate investors.”
He explained, if you purchase a property for $100,000, and it has appreciated to $1 million, you would be selling it at a $900,000 gain, which can be taxed at quite a high rate. However, under the 1031 exchange as it stands now, you can defer that tax payment by reinvesting your profits into another rental property.
“You could take all that gain and fully invest in the replacement property and not pay one penny of taxes,” Getty said. “That’s been a technique used in real estate since 1921.”
The $500,000 tax bracket doesn’t only apply to those whose yearly wages are above $500,000.
“In the year you’re selling the property, you’re going to be thrust into that higher tax bracket, and people just don’t think about that,” Getty said. “There’s no exception for occasional events like that.”
For many middle class investors, this capital gains tax change is “a big deal,” Getty noted. Those investors are temporarily pushed into a higher tax bracket if their property sale garners a large profit.
Getty’s clients include investors from widely different backgrounds, some very wealthy, who also invest in stocks and bonds. Others are smaller, with primarily real estate investments. He described those real estate investors, who make up a majority of his clients, as “mom and pop investors,” or “folks who started with single-family rentals. They built portfolios, and those properties appreciated.”
Because only a small percentage of the nation makes above $400,000, it’s easy to justify the capital gains tax changes as something affecting only the very wealthy. But, as Getty pointed out, the middle class investors wind up getting taxed greater due to the profit from a sale of property.
“Typically, in the year that you’re selling a property, you’re bumped up to the maximum [tax bracket],” Getty said.
As a result, many middle class investors are now scrambling for a solution and selling their properties before a tax increase hits.
“They are trying to get their transactions done this year,” Getty explained, because it’s still uncertain how severely the changes coming in 2022 will impact investors.
Getty also said many people, to secure their futures, are taking those capital gains and putting them into retirement accounts or real estate investment trusts (REITs), which can generate quite a bit of profit over time.
REITs are companies that invest in real estate for you. Rather than investing in a product like Apple or Amazon, for instance, REIT holders are generating income that comes with some amount of tax benefits. For the most part, real estate appreciates in value year-to-year.
“I’ve not seen anything in these tax proposals that’s going to harm REITs,” Getty said.
So while we don’t know for sure what these capital gains tax changes will be, many investors are now frantically selling their properties before the new year to avoid paying high taxes come 2022.