President Joe Biden is calling on Congress for a tax hike on real estate investors to help fund the $1.8 trillion American Families Plan, but it could lead to some unintended consequences for the housing market.
I discussed this topic in a recent video on LinkedIn, but here’s a written recap that might be a little easier to digest.
The plan includes two relevant features: an increase in capital gains tax rate from 20% to nearly 40% for those who earn more than $1 million per year, as well as the elimination of the “1031 Exchange Rules” provision of the IRS tax code for properties sold for more than $500,000 in profit. 1031 exchanges allow investors to defer paying taxes on real estate by exchanging profits earned from the property sold to another property in the investor’s portfolio, thereby deferring the tax burden.
Under this tax scenario, someone who's been sitting on a property for a while, thinking about selling, will be paying a much higher chunk of taxes on profit and may be disincentivized to sell as a result. That means even less supply for an already constrained housing market, demand and supply get even more outsized and prices continue to appreciate.
Let’s take a look at the current demand/ supply dynamic: millennials are entering the market because of the historically low interest rates and remote work environment -- these different factors have led to high demand for housing supply that doesn’t exist. The skyrocketing costs of building supplies add to the housing constraint thereby driving house prices higher.
Simply put, there's just not as much inventory in the market available to buy relative to population growth, which is resulting in multiple offers on properties that get listed and houses selling way over the asking price.
And, how does the increase in capital gains tax break down?
Under President Biden’s plan, for example, a property purchased for $500,000, and sold for $1 million is going to be subject to capital gains appreciation because it's classified as an asset and won’t be considered income. Under the current capital gains rate if the purchaser is an investor, they would pay somewhere in the ballpark of 20% tax on that sale. Under the new plan, investors face paying 40% to 50% of the profit in capital gains tax.
Biden’s plan also aims to reel in 1031 exchanges on transactions with profits exceeding $500,000. Currently, investors can use 1031 exchanges to buy and sell tax-deferred real estate throughout their lives. And, if the investor holds the “exchanged” property until death, they can pass it on to heirs tax-free. The congressional Joint Committee on Taxation estimated that 1031 exchanges may have saved investors around $41 billion in taxes from 2020 to 2024.
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