President Joe Biden’s policies and tax plans are becoming increasingly more relevant as his time in office begins. When it comes to the real estate industry or investing in general, it’s important to pay attention to policies that will affect you as a business owner so you can make the necessary adjustments. The Biden plan was published as a component of the platform for the Democratic Party. In order for this plan to become a reality, it still needs to pass Congress and most likely will have extensive amendments.
Just remember for this article, I am not a CPA. I am writing this as an investor and business owner. I find it helpful to understand how certain policies could affect the various aspects of my business, such as contractors, employees, lenders, buyers and investors. Please speak to your CPA before implementing any of these strategies. Below is a breakdown of the six main components of Biden’s tax plan and an explanation of how they might affect entrepreneurs and business owners.
Social Security Payroll Tax
Currently, employers and employees are taxed at 12.4% up to $137,700 in wages. No taxes are due beyond that wage. There is a proposal for an additional social security tax for anyone making above $400,000 at a rate of 12.4%. Anyone making less than $400,000 will not see any changes under this proposal.
Some business owners may want to modify their structures to avoid paying this as self-employed individuals. If you have an S Corp, you may consider reducing your wage below $400,000 and paying yourself a larger distribution instead.
Tax Bracket For Ordinary Income
The Tax Cut and Jobs Act (TCJA) of 2017 reduced the tax rate of top earners from 39.6% to 37%. The Biden plan proposes bringing the tax back to 39.6% and lowering the top tax bracket from $518,000 to $400,000 of adjusted gross income.
Limiting Itemized Deductions
The Biden plan proposes the reinstatement of the Pease Limitation on itemized deductions. Additionally, the tax plan seems to reduce the effective tax benefits of these deductions from 39.6% to 28% for those earning more than $400,000 of adjusted gross income. The elimination of the Pease Limitation was a recent change implemented in 2018, so it might be difficult to pass a reinstatement through Congress.
Phasing Out The QBI Deduction
This deduction was implemented as part of the TCJA of 2017. Currently, if you have an S Corp, you’re allowed to pay yourself with a W2. And, because you’re paying wages, you’re able to deduct 20% Qualified Business Income (QBI) on their taxes. Under the Biden tax plan, the deduction would be eliminated for adjusted gross income over $400K.
Long-Term Capital Gains
The Biden tax plan proposes three major changes to how long-term capital gains will be taxed. The first proposed change is the elimination of the 1031 exchange. If you’re unfamiliar with the 1031 exchange, it allows the deferment of capital gains by first selling a real estate investment property and then acquiring a like-kind investment property within a specific time period.
The second proposed change is a massive increase of the long-term capital gains tax from the current 20% up to the ordinary income level of 39.6% for Adjusted Gross Income over $1,000,000. Typically, long-term capital gains are taxed at a top bracket of 20% depending on the amount of capital gains. The $1 million limit may sound rather large, but for many Americans who live on either the East or West Coast of the U.S., these gains are not hard to come by.
The third proposed change would eliminate the step-up basis. A step-up in basis is the readjustment of the value of an asset for tax purposes upon inheritance. So, for instance, if you own property and that property gets passed onto your descendants, the value of that asset for taxes would be adjusted to market value so that if your descendants decide to sell the asset at that time, there will not be any capital gains.
In my opinion, I do not believe that these changes to long-term capital gains will pass Congress. The average age of the members of Congress is 57 years old, and many of them have significant real estate investments that they are planning to pass on to their descendants. This poses many problems for people that are relying on the equity of their home to provide for them at retirement. Also, we are in the middle of the baby boomers’ retirement phase, and politicians may not want to change the rules on them at the last minute.
Lower Estate Tax Exemption
Currently, there is a 40% estate tax for asset value above $11.58 million. The Biden plan proposes to increase the tax rate to 45% and, more importantly, reduces the exemption from $11.58 million to $3.5 million. Again I believe that this change will not be able to pass Congress. Even some influential democrats may vote against such changes that would significantly impair their descendants. If it were to pass, many Americans would need to reconsider and potentially restructure their living trust to protect it for their children. These changes seem to affect more people who have managed to accumulate a little bit of wealth to enable their retirement and leave a legacy for their children. I cannot imagine that a majority in the senate or even the house would vote in favor of this tax plan.
In summary, while the likelihood that this plan is implemented in its current form is extremely unlikely, it’s important for business owners throughout the real estate industry to familiarize themselves with potential outcomes. There is a significant amount of negotiation that would need to occur before going to a vote, but it’s not impossible for discussions to end in change.