Go After Real Estate?

During the 2020 presidential campaign, there was one segment of the “rich” for which then-candidate Biden seemed to have reserved some of his harshest criticism – wealthy real estate investors. Moreover, the Democratic Party’s platform included several proposed changes to the Code[i] the impact of which would probably be felt most keenly by such investors.[ii]

Query the origin of this posture. Was it grounded – pun intended – in the Party’s association, rightly or wrongly, of the real estate industry with Mr. Trump?[iii] But how can this be reconciled with the sizable contributions made by industry leaders to Mr. Biden’s campaign and to political action committees that supported him?[iv]

Regardless of why candidate Biden identified the federal taxation of real estate as an example of what he described as the Code’s special treatment of the wealthy,[v] President Biden recently proposed that the Code be amended to limit many of the favorable provisions upon which real estate investors have long relied for purposes of evaluating the acquisition, operation, and disposition of investment properties.

Biden’s Proposals & Some Observations

You may recall that the White House, late last month, released a summary[vi] of the amendments to the Code proposed by the President as part of his American Families Plan.[vii]

What follows is a description of four of the changes sought that may be of special interest to individuals who are invested in real estate or who own interests in closely held entities that hold real estate investments; specifically, the increased rate at which capital gains are taxed, the elimination of the step-up in the basis of a taxpayer’s assets at the death of the taxpayer, the deemed sale of a taxpayer’s assets at the time of their death, and the limitation on the use of like kind exchanges.

These descriptions are accompanied by observations that may be helpful in considering the impact of the proposed changes on a taxpayer and on their tax planning.

Increased Rate on Capital Gains

  • An increase of the top tax rate for long-term capital gains from 20 percent to 39.6% for individuals making over $1 million.[viii]
    • The tax on the gain recognized from the sale or exchange of real property that the taxpayer has held for investment, or for use in a trade or business, for more than one year[ix] will almost double.[x]
    • The same rate hike will apply to the long-term capital gain from the sale or complete liquidation/redemption[xi] of a partnership interest or of stock in a corporation where the business entity owns real estate.
    • Likewise, the increased rate will apply to dividend distributions by a corporation.
  • Query whether taxpayers will try to remain below the $1 million threshold at which the higher rate will be triggered.
    • Installment sales may be an option, provided the credit risk of the deferred payments is acceptable.
      • Consider a guarantee of the installment obligation[xii] by a party related to the purchaser, or perhaps a standby letter of credit.
    • A taxpayer must be aware of the special interest charge imposed with respect to installment obligations greater than $5 million.[xiii]
    • The taxpayer must also understand that the gain from certain assets does not qualify for installment reporting; for example, depreciation recapture for those taxpayers who may have used a cost segregation study to accelerate the depreciation of certain components of a real property.
  • Other taxpayers may decide they should close on a transaction before the end of 2021 (assuming an effective date of January 1, 2022 – stay tuned) to secure the lower rate.
    • To provide the most flexibility, a taxpayer may consider receiving part of the purchase price for a sale of property before the year-end, together with an installment note; depending upon the amount of the rate hike, or the timing thereof, the taxpayer may decide to elect out of installment reporting and report the entire gain represented by the note in 2021.[xiv]

Limit the Basis Step-Up at Death

  • With the Deemed Sale Rule. Eliminate the basis step-up[xv] for property acquired or passing[xvi] from a decedent if the gain inherent in the property at the time of death[xvii] exceeds $1 million ($2.0 million per couple[xviii]).
    • Query the effect of this change where the decedent previously “sold” appreciated property to a grantor trust of which the decedent is treated as the owner for income tax purposes,[xix] in exchange for a promissory note;[xx] is the “sale” completed at the grantor’s date of death, when the trust ceases to be disregarded for purposes of the income tax?[xxi] If so, then subsequent payments of principal will be taxable in accordance with the installment sale rules.[xxii]
    • The death of a partner has long been considered an appropriate time for adjusting the estate’s share of the partnership’s adjusted basis for its assets (the “inside basis”).[xxiii]
      • The amount of this adjustment is determined by comparing the estate’s adjusted basis for its partnership interest (the “outside basis”) with its share of the inside basis – a positive basis adjustment is treated as a new asset that may be depreciated by the estate (assuming the adjustment to its share of inside basis is attributed to a depreciable asset).
      • The adjustment may also be used to reduce the estate’s share of gain from the partnership’s sale of the property to which the adjustment is attributed.
      • The elimination of the basis step-up at death seems to deprive the estate of the opportunity to adjust its share of inside basis by reference to its stepped-up outside basis. (But see below.)
    • Without the Deemed Sale Rule. If the deemed sale rule (discussed below) is not enacted – and I think it will be difficult for Congress to accept such a significant change – then the loss of the basis step-up has a better chance of being enacted, subject to a palatable exemption amount – as indicated above, $1 million has been proposed.[xxiv]
      • The elimination of the basis step-up rule will impact anyone receiving property from a decedent, whether by way of the decedent’s will, revocable trust, or by operation of law (for example, someone who owns real property jointly with the decedent, with right of survivorship such that the decedent’s interest passes to them upon the decedent’s death).
        • By denying these individuals an increase in the basis of the property they receive upon the decedent’s death, these individuals will realize a greater gain on the subsequent sale of the property.
          • This will take on greater significance for real estate in the event Congress also goes along with Mr. Biden’s proposal (see below) to limit a taxpayer’s ability to use a like kind exchange to defer the recognition of gain from the sale of real property.
        • In the case of property that is depreciable (such as a building), the individual beneficiary will lose the ability to depreciate the additional basis that the step-up would have provided, effectively making the ownership of the real property more expensive.
        • This will also impact beneficiaries receiving partnership interests, especially where the partnership is highly leveraged. The post-death transfer of such an interest will be treated as a taxable event even where the transferor-beneficiary receives no cash in exchange – the amount of the partnership debt allocated to the decedent’s interest for tax purposes (as reflected on the Sch. K-1) will be treated as cash paid to the transferor-beneficiary; basically, phantom income.[xxv]

Deemed Sale at Death

  • Tax the gain inherent in a decedent’s property (less $1 million of gain – think of it as an exemption) as if the property had been sold to a hypothetical, unrelated buyer[xxvi] for an amount equal to its fair market value at the date of death.
    • The elimination of the basis step-up at death (see above) causes this deemed-sale-at-death to be taxable.
    • The assets deemed to have been sold will include the decedent’s direct and indirect interests in real property.
      • Indirect interests will include shares of stock in a corporation, or interests in a partnership, that owns real property.
    • The gain therefrom will be determined by reference to the decedent’s adjusted basis in the property “sold” immediately before their demise.[xxvii]
    • The decedent’s estate will pay the income tax owing from the deemed sale. Presumably, the estate will be entitled to a deduction for the tax paid for purposes of determining its estate tax liability.
    • Assuming Congress increases the capital gain rate,[xxviii] which seems likely, the amount of tax owing from the deemed sale could be sizable, especially for highly appreciated assets.
      • How will the estate finance the payment of the federal income tax? If the states conform to the proposed federal change, state and local income taxes will also have to be considered.
      • Will the decedent’s estate also be subject to federal estate tax? The President’s proposal makes no mention of the estate tax.
        • In the absence of other guidance, both taxes may apply to the same estate.
        • The income tax may apply to an estate that currently is not subject to the estate tax.[xxix]
      • Insurance on the life of the deceased taxpayer may assume an even greater role in terms of providing the liquidity required by the estate to satisfy both the income tax and the estate tax.
    • Following such a deemed sale, however, a beneficiary of the decedent’s estate will take the decedent’s property with a basis equal to the fair market value of the property – a stepped-up basis – because the gain will have already been taxed once (on the deemed sale).
      • The subsequent actual sale by the estate or beneficiary will not cause the pre-death built-in gain to be taxed again.
      • The increased basis will give the beneficiary an asset that may be depreciated going forward, at least where the decedent owned a direct interest in real property
      • From this, it should follow, in the case of a decedent who owned an interest in a partnership for which a Section 754 election has been made, that the estate’s share of the inside basis may be adjusted.
      • The S corporation rules do not provide a similar inside basis adjustment with respect to the corporation’s assets.
    • Under the deemed sale rule, gain would be realized and taxed even where there has been no appreciation in the value of the property, but the taxpayer’s adjusted basis for the property – or for their indirect interest in the property (for example, the basis for their partnership interest) – has been reduced on account of depreciation and other deductions claimed in respect of the property.
    • Is it odd that a smaller estate, not subject to the federal estate tax (because the taxable estate is less that the amount of the federal estate tax exemption), will enjoy a basis step-up for its appreciated assets (and not incur an income tax), while a larger estate, that is subject to the estate tax, may be denied the basis adjustment, and thereby be subjected to tax twice on the same assets[xxx] – once for income tax purposes and once for estate tax purposes.

Limit the Like Kind Exchange

  • Eliminate the like kind exchange[xxxi] for real property where the gain realized exceeds $500,000.
    • This appears to be a per investor limit; however, the President’s proposal is short on detail.[xxxii]
    • It is also likely that this represents an annual limit; in other words, an individual taxpayer will not be able to defer more than $500,000 of gain in any single taxable year using a like kind exchange, including exchanges effected by partnerships or S corporations in which the taxpayer is an owner (to the extent of the taxpayer’s share thereof).
      • Query whether the owner of a real property held for investment, and with significant built-in gain, should place the property into a partnership with members of their family; if done well before any disposition is contemplated, the partnership should satisfy the qualified use or “held for” requirement of the like kind exchange rules, while also positioning the family to take advantage of any deferred-gain-per-taxpayer limitation that may be enacted.[xxxiii]
    • A taxpayer who is planning to dispose of real property (the relinquished property) as part of a like kind exchange should consider closing this year (assuming a January 1, 2022 effective date) to be exempted[xxxiv] from the new rule.
    • A New York resident who has been considering whether to “remove” their real property from New York by disposing of such property and using a like kind exchange to acquire replacement real property in a tax-friendlier jurisdiction, may want to implement this strategy sooner rather than later.
      • Such a transaction may be utilized as part of a plan to reduce the taxpayer’s New York estate,[xxxv] to position the taxpayer for gifts that fall outside the clawback rule, or to support the taxpayer’s claim to have abandoned their New York domicile.[xxxvi]
    • Although the change would apply to direct swaps of property, to deferred exchanges, and to reverse exchanges, query whether it will also apply to the mixing bowl rule exception that avoids gain recognition by a contributing partner when the partnership distributes the contributed property to a non-contributing partner and distributes like kind property to the contributing partner.[xxxvii]

Parting Thoughts

It behooves the individual real estate investor and their advisors to consider the foregoing legislative proposals (as well as the related observations) in greater detail, and to plan for the possibility that one or more of these provisions may be enacted as proposed or, more likely, in some modified form. This process will prepare the taxpayer to respond effectively and relatively quickly, if necessary.

Among the other items to consider is the use of life insurance, held by an irrevocable life insurance trust, as a way of replacing the “lost economic benefit” that would otherwise have been realized from the basis step-up. The beneficiary will receive the life insurance proceeds free of income tax. The decedent can gift or loan the amount of the premium.[xxxviii]

Life insurance may also be prudent in the event the deemed sale rule is enacted, especially in the case of an estate comprised mostly of interests in real property, and with few liquid assets.[xxxix]

Finally, keep abreast of developments in Washington, D.C. – and follow our posts.

A word about the title. The full phrase, from the Anglican funeral service, is “Earth to earth, ashes to ashes, dust to dust.”

[i] It should not require clarification, but for the benefit of new readers, there is only one “Code”: The Internal Revenue Code. Distant competitors for the title include Justinian’s Code (which provided the foundation for legal codes throughout Europe – yet the West continues to ignore its debt to Byzantium), and Hammurabi’s Code (known for its “if this, then that” format, not to mention its very harsh punishments – the so-called “laws of retribution”). The bankruptcy code (lower case “c”)? Not so much.

[ii] For example, at one point the candidate called for the elimination of bonus depreciation for real estate. Under this rule, a taxpayer can deduct immediately the cost of real property improvements (say, landscaping) with a useful life of up to 15 years.

During the primaries, other candidates questioned the need for depreciation deductions for real property, which tends to appreciate.

[iii] A perverted application of the law of transitivity: Dems hate Trump; Trump likes real estate; Dems hate real estate? Perhaps it would be more accurate to characterize the position as stemming from the concept of “guilt by association”?

[iv] https://therealdeal.com/2020/09/10/real-estate-donors-backing-biden-over-trump/ .

[v] You may enjoy these quotes on investing in real estate: https://www.realtymogul.com/knowledge-center/article/20-famous-real-estate-investing-quotes .

[vi] https://www.rivkinradler.com/publications/tax-highlights-the-american-families-plan/ .

[vii] https://www.whitehouse.gov/briefing-room/statements-releases/2021/04/28/fact-sheet-the-american-families-plan/

[viii] Mr. Biden has proposed to increase the top federal income tax rate for individuals from 37 percent to 39.6 percent. This increased rate will apply to interest payments on loans made by an individual taxpayer-lender to a business entity to assist it in acquiring or improving real property. It will also apply to an individual’s share of a partnership’s or S corporation’s ordinary business income from a real property business, as well as their share of net rental real estate income. See Lines 1 and 2 of Part III of Sch. K-1 to Form 1065 (partnership tax return) and to Form 1120-S (S corporation tax return).

And do not forget the 3.8% surtax on net investment income under IRC Sec. 1411 if the individual taxpayer is not a material participant in the business. See IRC Sec. 469 and Reg. Sec. 1.1411-5.

[ix] IRC Sec. 1223.

[x] IRC Sec. 1(h), Sec. 1221, and Sec. 1231.

[xi] It never hurts to remind folks that, in general, the gain recognized by a partner on the liquidation of their interest in a partnership will be treated as gain from the sale or exchange of the partnership interest, which in turn is generally treated as gain from the sale or exchange of a capital asset. IRC Sec. 736(b), Sec. 731(a), and Sec. 741.

As always, when dealing with a partnership, beware “hot assets” under IRC Sec. 751, and the deemed distribution of cash under IRC Sec. 752.

Where the liquidation of a partnership interest is effectuated by an in-kind distribution of property, see if the “mixing bowl” rules of IRC Sec. 704(c)(1)(B) or Sec. 737 apply.

[xii] IRC Sec. 453(f)(3).

[xiii] IRC Sec. 453A.

[xiv] IRC Sec. 453(d). The election must be made on or before the due date (with extension) for the return on which the sale will be reported.

[xv] IRC Sec. 1014.

[xvi] Query whether this will include property that the decedent gifted while living but which is nonetheless included in their gross estate for purposes of the federal estate tax; for example, because the donor continued to enjoy the economic benefits of the gifted property. IRC Sec. 2036.

Such property is currently subject to a basis adjustment at the death of the decedent-donor. IRC Sec. 1014. Indeed, there are times when the decedent’s estate, which is otherwise subject to estate tax, will try to include the gifted property in the gross estate in order to secure a basis step-up.

[xvii] The excess of its fair market value over the decedent’s adjusted basis, both determined as of the date of death.

[xviii] Does this imply some sort of portability rule, similar to that which allows a surviving spouse to utilize the unused estate/gift tax exemption of a predeceasing spouse?

[xix] IRC Sec. 671 et seq.

[xx] The holding of Rev. Rul. 85-13 underlies such transactions.

[xxi] See my article on the internet at https://www.taxlawforchb.com/2015/08/sale-to-idgts-the-death-of-the-grantor/ .

[xxii] IRC Sec. 453.

[xxiii] The partnership must elect to make this adjustment; it is not automatic. Once made, however, the election will apply to all subsequent transfers for which an inside basis adjustment may be available. IRC Sec. 754 and Sec. 743.

[xxiv] I can see this going to $5 million, adjusted for inflation, to match the estate tax exemption (this was the basic exclusion amount before 2018 and will be reinstated beginning in 2026, if not sooner); in this way, an estate that is not subject to estate tax will also not be subject to income tax. (I hope they read this in Washington.)

[xxv] IRC Sec. 752. I prefer to think of it as the recapture of tax benefits attributable to the debt.

Partners in burnt out tax shelters relied heavily upon the basis step-up at the death of the partner to avoid this phantom gain. See Reg. Sec. 1.742-1(a), pursuant to which the adjusted basis of a decedent’s partnership interest is equal to the fair market value of the interest, plus the amount of partnership debt allocated to the interest under IRC Sec. 752 and the regulations thereunder.

[xxvi] After all, the fair market value of a property is the price at which the property would change hands between a hypothetical willing buyer and a hypothetical willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

For a review of the income tax consequences of sales between related parties, please see my article on the internet at https://www.taxlawforchb.com/2013/12/related-party-sales/ .

[xxvii] The elimination of the step-up is what makes this deemed sale taxable.

[xxviii] Whether to 39.6%, as proposed, or to a lower rate – I am thinking 24.2%; adding the 3.8% Obamacare tax (under IRC Sec. 1411) would bring the rate to 28%.

[xxix] The latter makes no sense. The income tax exemption (as proposed, $1 million of gain per decedent) should be the same as the estate tax exemption. If an estate is to be exempt from the estate tax, it should also be exempt from the income tax. This may turn into a negotiating point if the size of the estate tax exemption is introduced into the legislative fray.

[xxx] Such a result has been the historical justification for the basis step-up – to avoid the imposition of both an estate tax and an income tax on the same assets.

[xxxi] IRC Sec. 1031 and the regulations promulgated thereunder.

[xxxii] For example, is this a per exchange limit or an annual limit?

[xxxiii] Query whether Congress may include attribution rules in the legislation to defeat this strategy.

[xxxiv] Grandfathered, really. The replacement property may be acquired in accordance with existing law.

[xxxv] NY Tax Law Sec. 954.

[xxxvi] New York has not yet adopted a rule like California’s, which “tracks” the investment of the proceeds from the sale of a real property located in the state to an out-of-state replacement property. When the replacement property is sold in a taxable transaction, the deferred California gain must be taxed.

[xxxvii] IRC Sec. 704(c)(2). See my article on the internet at https://www.taxlawforchb.com/2017/03/effecting-exchanges-of-property-through-a-partnership/ .

[xxxviii] Perhaps as a form of private split-dollar.

[xxxix] That said, loans secured by the properties may be possible; for example, Graegin loans. See my article on the internet at https://www.taxlawforchb.com/2017/05/paying-the-estate-tax/ .