Background
As originally outlined in his “American Families Plan” on April 28, Biden’s individual tax proposals included increasing the top individual ordinary income tax rate from 37% to 39.6%, taxing capital gains and qualified dividend income at ordinary rates for individuals with income above $1 million, limiting the use of “step-up in basis” rules, and closing the “carried interest loophole”.
Biden has proposed a series of revenue offsets to pay for his American Jobs Plan by increasing the corporate tax rate and changing certain U.S. international tax rules. In addition, to pay for his American Families Plan, Biden has proposed rolling back several individual tax cut provisions included in the 2017 tax reform act for individuals with income above $400,000.
Individual income tax rate increases
The Green Book describes Biden’s proposal to increase the top marginal tax rate from 37% to 39.6% for tax years beginning after December 31, 2021, reversing the tax cuts implemented as part of the 2017 federal tax reform act.
Currently, the highest marginal rate applies to taxable income in excess of $628,300 for married individuals filing a joint return and surviving spouses, $523,600 for unmarried individuals (other than surviving spouses) and head of household filers, and $314,150 for married individuals filing a separate return. The proposed rate increases would apply in tax year 2022 to taxable income over $509,300 for married individuals filing a joint return, $452,700 for unmarried individuals (other than surviving spouses), $481,000 for head of household filers, and $254,650 for married individuals filing a separate return.
Opinion: Depending on your circumstances, an individual may want to consider accelerating income into 2021 if possible or delaying deductions to 2022 if the top marginal rates are increased.
Taxing capital gains and qualified dividends at ordinary rates
Under current tax rules, most long-term capital gains and qualified dividends are subject to a preferential 20% top marginal tax rate (excluding the additional 3.8% net investment income tax rate that is applied to certain investment income) for all individual taxpayers. Biden is proposing an increase of the long-term capital gains rate from 20% to 39.6% (the same top marginal rate as is proposed for ordinary income) to the extent a taxpayer’s adjusted gross income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022.
In contrast to other individual tax provisions that generally are proposed to be effective for tax years beginning after December 31, 2021, Biden’s proposal to increase capital gains tax rates is proposed to be effective “for gains required to be recognized after the date of announcement.” Although not specified in the Green Book, Biden administration officials have indicated that the “date of announcement” is meant to be April 28, 2021 — the date Biden announced his American Families Plan. At any rate, this immediate, or possibly retroactive, effective date may represent an effort on the part of the Biden Administration to prevent a race to sell assets in advance of an increase in rates.
Opinion: A retroactive effective date prior to the date of enactment for a capital gains rate increase is unusual. By contrast, reductions in capital gains tax rates in recent decades have been effective on the date first proposed by Congress — for example, the date such a proposal is first offered by the chairman of the House Ways and Means Committee. Neither the tax increase on capital gains included in the Tax Reform Act of 1986 nor the tax increase resulting from the enactment of the net investment income tax in 2010 were made effective prior to the enactment date of the respective legislation. Furthermore, it is important to recognize that the Biden Treasury Department cannot set the effective date for legislation—the ultimate effective date will be established by Congress and will be the product of negotiations among numerous stakeholders.
The Green Book states that “[l]ong-term capital gains and qualified dividends of taxpayers with adjusted gross income of more than $1 million would be taxed at ordinary income rates, with 37 percent generally being the highest rate (40.8 percent including the net investment income tax), but only to the extent that the taxpayer’s income exceeds $1 million ($500,000 for married filing separately), indexed for inflation after 2022.” Although not entirely clear, the intention appears to be that capital gains would be taxed at the top ordinary income rate, which would be 37 percent from the date of announcement until December 31, 2021, and then 39.6 percent thereafter.
As described in the Green Book, the income thresholds do not appear to represent a cliff. Instead, the increased rate applies only on the portion of capital gain that is part of total taxable income in excess of $1 million (or $500,00 for married taxpayers filing separately). For example, a married couple filing jointly who has total taxable income of $1.2 million, of which $400,000 is capital gain, the 39.6 percent rate would apply to $200,000 of capital gain (i.e., the portion in excess of $1 million).
Treat transfers of appreciated property by gift or on death as taxable events
A proposal that may have a significant impact on income and wealth planning if enacted is the Administration’s proposal to tax certain previously untaxed transfers of appreciated property, if transferred by gift or on the death of the owner. Currently, a seller recognizes a taxable gain (determined by subtracting their basis from the purchase price) only when an appreciated asset is sold.
This proposal would be effective for gains on property transferred by gift, and on property owned at death by decedents dying, after December 31, 2021, and on certain property owned by trusts, partnerships, and other noncorporate entities on January 1, 2022.
A transfer by gift of appreciated property currently does not result in the imposition of any income or capital gain taxes; instead, the recipient of the appreciated property (the donee) receives the basis that the owner had at the time of the transfer (carryover basis). Therefore, the imposition of tax on the gain is deferred until the donee later sells the property.
A transfer of an appreciated asset on the death of the owner to a beneficiary is also not currently subject to tax due to the “step-up (or down) in basis” rule, which generally provides that the basis of appreciated property distributed by an estate to the beneficiary will be the fair market value of the asset at the time of the decedent’s death.
Consequently, any appreciation of the asset that occurred during the decedent’s life and ownership of the asset would never be subject to tax. After death, if the beneficiary subsequently sells the asset, taxable gain would only be realized on the appreciation occurring from the decedent’s date of death to the date of the sale.
As explained in the Green Book, Biden is proposing that the donor or deceased owner of an appreciated asset would realize a capital gain at the time of the transfer, which would be subject to capital gains tax, subject to the exclusions and limitations noted below. Obviously, the current rules providing for a step-up in asset basis at death encourage many individual taxpayers to hold appreciated assets until death. These rules also may affect decisions made by large real estate partnerships when one or more partners have significant gains for assets held by such partnerships. While this proposal is among the most controversial in the Green Book, if enacted, it could change behavior significantly regarding decisions to sell assets.
For a donor, the amount of the gain realized would be the excess of the asset’s fair market value on the date of the gift over the donor’s basis in that asset. For a decedent, the amount of gain would be the excess of the asset’s fair market value on the decedent’s date of death over the decedent’s basis in that asset. It appears that capital losses and carryforwards may be utilized against the gain and any taxes imposed on gains at death would be deductible on the decedent’s estate tax return.
An example of the proposal’s application may help to clarify:
Assuming a decedent has no remaining gift and estate tax exemption and is taxed at the top marginal estate tax rate, an appreciated asset held at death with a fair market value of $500,000 and a tax basis of $100,000 generating a $400,000 gain would incur a capital gains tax of $173,600 ($400,000 x 43.4%) and an estate tax of $130,560 ($500,000-$173,600 x 40%) resulting in total tax of $304,160.
What constitutes a transfer and how the asset and gain are valued would be determined under the gift and estate tax provisions, however, for purposes of the imposition of tax on appreciated assets, the following would apply:
- A transferred partial interest would be valued at its proportional share of the fair market value of the entire property.
- Transfers of property into, and distributions in kind from, a trust, partnership, or other non-corporate entity, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events.[1] Additionally, the deemed owner of such a revocable grantor trust would recognize gain on the unrealized appreciation in any asset distributed from the trust to any person other than the deemed owner or the US spouse of the deemed owner, other than a distribution made in discharge of an obligation of the deemed owner. All unrealized appreciation on assets of such a revocable grantor trust would be realized at the deemed owner’s death or at any other time when the trust becomes irrevocable.
The Green Book also indicates that certain unrealized gains of appreciated property owned by a trust, partnership, or other non-corporate entity will be subject to tax if it has not been subject to tax within the last 90 years, with the testing period starting on January 1, 1940. Consequently, the first time such assets may be subject to tax would be December 31, 2030. This additional proposal was unexpected, given that it was not described in the fact sheet issued in connection with the American Families Act.[2] This proposal would require unrealized gain in assets owned by a trust, partnership, or other non-corporate entity to be recognized if the property has not been the subject of a recognition event within the prior 90 years. Testing for the 90-year holding period would be for periods beginning January 1, 1940. As a result, a recognition event could not occur until December 31, 2030.
In addition, the Green Book contains the following statement: “[T]ransfers of property into, and distributions of property in kind from, a trust, partnership, or other non-corporate entity, other than a grantor trust that is deemed to be wholly owned and revocable by the donor, would be recognition events.” At first blush, the statement would seem to create great concern, as it appears to indicate an intention to override the nonrecognition provisions—sections 721 and 731—applicable to partnership contributions and distributions. This statement is made following statements indicating that a “transfer” for purposes of the gain recognition provision relevant to gifts and bequests generally would be defined under the estate and gift provisions, but that certain special rules would apply. Read in context, it appears that the provision would be intended to apply only when the contribution or distribution would result in a gift under the estate and gift tax provisions.[3]
The Green Book lists the following exclusions and limitations to gain recognition and tax payment:
- A $1 million (indexed for inflation after 2022) per-person exclusion from recognition of other unrealized capital gains on property transferred by gift or held at death. The $1 million exclusion would be portable to the decedent’s surviving spouse (the exclusion would be $2 million per married couple).
- Certain transfers to a U.S. spouse or to charity would not trigger capital gain. The basis would be carried over and capital gain would not be recognized until the spouse disposes of the asset or dies. Appreciated property transferred to charity would not generate a taxable capital gain.
- The current capital gain exclusion on certain small business stock would continue to apply. This proposal appears to be referencing qualified small business stock, but this is not completely clear.
- Any gain on tangible personal property such as household furnishings and personal effects (excluding collectibles).
- The $250,000 per-person exclusion under current law for capital gain on a principal residence would apply to all residences and would be portable to the decedent’s surviving spouse (making the exclusion effectively $500,000 per couple).
- Payment of tax on the appreciation of certain family-owned and operated businesses would not be due until the interest in the business is sold or the business ceases to be family-owned and operated.
- A 15-year fixed-rate payment plan for the tax on appreciated assets transferred at death, other than liquid assets such as publicly traded financial assets and other than businesses for which the deferral election is made, would be available. Note: This proposal appears to be based on a current law provision that provides the same terms for estate tax payments though that rule is designed for estates with heavy portions of family farms and small businesses.
Opinion: Although the Green Book provides some additional details, there are still a number of unanswered questions. Among the many open questions for which more information is needed are 1) which family-owned and operated businesses would qualify for the preferential treatment, 2) clarification on whether just gifts and bequests are covered or whether all transfers to/from trusts, partnerships, and other non-corporate entities are covered, and 3) whether partnership is intended to mean only family limited partnerships, and additional detail on how the tax would be reported.
The Green Book proposals are also vague regarding if any transition relief would apply: Would the elimination of the step-up in basis apply to all appreciation existing on all assets held by a decedent who dies after the effective date, or only to appreciation that occurred after the effective date?
Real estate is often passed within a family from generation to generation, so this provision could have a significant impact on such family-held assets. In addition, the proposal would appear to require recognition of an asset’s unrealized appreciation that has not been the subject of a recognition event during the prior 90 years regardless of whether the impacted entity itself has held the property for 90 years. This could raise due diligence concerns in connection with tax-deferred acquisitions, including contributions to a partnership.
Expand the imposition of the Net Investment Income Tax and Self-Employment contributions Act taxes for pass-through entity owners
Individuals with income over $200,000 for single and head of household returns and $250,000 for joint returns are subject to the Net Investment Income Tax (NIIT), which is imposed on net investment income at 3.8%. For purposes of the NIIT, net investment income generally includes certain types of investment income but does not apply to self-employment earnings. Specifically, net investment income includes: (1) interest, dividends, rents, annuities, and royalties, other than such income derived in the ordinary course of a trade or business; (2) income derived from a trade or business in which the taxpayer does not materially participate; (3) income from a business of trading in financial instruments or commodities; and (4) net gain from the disposition of property other than property held in a trade or business in which the taxpayer materially participates.[4]
Self-employment earnings and wages are subject to employment taxes under either the Self Employment
Contributions Act (SECA) or the Federal Insurance Contributions Act (FICA), respectively.
General partners and sole proprietors typically pay SECA tax on the full amount of their net trade or business income; however, Section 1402(a)(13) provides that limited partners are statutorily excluded from paying SECA tax with respect to their distributive shares of partnership income or loss. Given the exclusion for limited partners, questions arose as to whether this also may be applied to members of limited liability companies.
Additionally, S corporation shareholders are not subject to SECA tax, but must pay “reasonable compensation” to themselves for services provided on which they pay FICA tax. Nonwage distributions to shareholders of S corporations are not subject to either FICA or SECA taxes. Consequently, the current FICA and SECA regimes result in dissimilar treatment of owners across pass-through entity types.
Given the limitations of the scope of the NIIT taxable income and the contrasting treatment of SECA and FICA across entity and ownership classification, the Biden proposal seeks to:
- ensure that all pass-through business income of high-income taxpayers is subject to either the NIIT or
SECA tax, - make the application of SECA to partnerships and LLCs more consistent for high-income taxpayers, and
- apply SECA to the ordinary business income of high-income nonpassive S corporation owners.
To implement these goals, the Administration’s proposal would subject all trade or business income of high-income taxpayers to the 3.8% Medicare tax, either through the NIIT or SECA tax; broaden the definition of net investment tax to include gross income and gain from any trades or businesses that otherwise is not subject to employment taxes for individuals with adjusted gross income in excess of $400,000; impose SECA tax on members’/partners’ distributive shares of partnership, LLC, or S corporation business income if they provide services and materially participate, to the extent that this income exceeds certain threshold amounts. Note: Exemptions from SECA tax for certain types of S corporation income would continue to apply.
These changes would be effective for tax years beginning on or after December 31, 2021.
Ending the “carried interest loophole”
Over the past several years, closing the “carried interest loophole” has been part of tax policy discussions that focus on the tax treatment of carried interest that is provided for certain partners in investment partnerships. The Green Book indicates that closing the “loophole” is intended to align what is often viewed as payment for services with the taxation of other ordinary income rather than providing capital gain treatment.
As explained in the Green Book, generally, partners may receive partnership interests in exchange for contributions of cash and/or property or may receive partnership interests, typically interests in future partnership profits (referred to as “profits interests” or “carried interest”) in exchange for services. Since the partnership itself is not subject to tax, if a partnership recognizes long-term capital gain, the individual partners, including partners who provide services, will reflect their shares of such gain on their tax returns as long-term capital gain, which is currently taxed at a preferential 20% rate.
Additionally, income attributable to a profits interest generally is subject to self-employment tax, except to the extent the partnership generates types of income that are excluded from self-employment taxes, e.g., capital gains, certain interest, dividends and certain rental income. Furthermore, a limited partner’s distributive share generally is excluded from self-employment tax.
Specifically, the Green Book proposes that a partner’s share of income on an “investment services partnership interest” (ISPI) in an investment partnership, regardless of the character of the income at the partnership level, would be taxed at ordinary rates if the partner’s taxable income (from all sources) exceeds $400,000. Additionally, partners in such investment partnerships would be required to pay self-employment taxes on such income.
The Green Book states that an ISPI is a profits interest in an investment partnership that is held by a person who provides services to the partnership. A partnership is an investment partnership if substantially all of its assets are investment-type assets (certain securities, real estate, interests in partnerships, commodities, cash or cash equivalents, or derivative contracts with respect to those assets), but only if over half of the partnership’s contributed capital is from partners in whose hands the interests constitute property not held in connection with a trade or business.
An exception to this treatment would apply to the extent that: (1) the partner who holds an ISPI contributes “invested capital” (which generally is money or other property) to the partnership, and (2) such partner’s invested capital is a qualified capital interest. This generally requires that (a) the partnership allocations to the invested capital be made in the same manner as allocations to other capital interests held by partners who do not hold an ISPI and (b) the allocations to these non-ISPI holders are significant. Similarly, the portion of any gain recognized on the sale of an ISPI that is attributable to the invested capital would be treated as capital gain. However, “invested capital” will not include contributed capital that is attributable to the proceeds of any loan or advance made or guaranteed by any partner or the partnership (or any person related to such persons).
Section 1061, which currently recharacterizes long-term capital gain related to carried interests held less than 3 years, exempts Section 1231 property and thereby excludes a significant portion of real estate capital gains from recharacterization. There is no indication that real estate would benefit from any exclusion from the carried interest provision described in the Green Book. Furthermore, the Green Book proposal would repeal section 1061 for taxpayers with taxable income (from all sources) in excess of $400,000 and would be effective for taxable years beginning after December 31, 2021.[5]
Opinion: If the capital gains rate proposal described above is passed, the carried interest proposal would have little impact. However, the carried interest proposal may be an attempt at a more permanent fix that might remain in effect regardless of any potential change to capital gains tax rates by the current Congress or a future Congress.
Eliminating like-kind exchange preferential treatment on certain gains
Currently, owners of appreciated real property used in a trade or business or held for investment can defer gain on the exchange of the property for real property of a “like kind.” The Green Book describes the Administration’s proposal to tax any gains from like-kind exchanges in excess of $500,000 in aggregate for each taxpayer (or $1 million in the case of married individuals filing a joint return) during a tax year. The proposal would be effective for exchanges completed in tax years beginning after December 31, 2021. Under this effective date, if a taxpayer transferred relinquished property in deferred section 1031 exchange in 2021 but completed the section 1031 exchange by acquiring the replacement property in 2022, the proposal would force recognition of all gain in excess of the $500,000 amount (or $1 million for married individuals filing jointly) in 2021.
Many real estate investors sometimes continue to exchange properties under Sec. 1031 until their death, at which point the decedent’s tax basis in the replacement property would be stepped-up to fair market value and the previously deferred gain could be avoided completely. The effective repeal of section 1031 for real property exchanges would significantly affect a number of parties in the real estate industry. Some business models rely heavily upon the availability of tax-free like-kind exchanges. For example, in Tenant in Common (“TIC”) structures the sponsor will typically divide a property paying stable rents that are available as replacement property for smaller-scale investors who would like to sell their property and acquire a replacement property in a deferred exchange property that has a constant and predictable income stream. It is likely that the limitation of nonrecognition treatment to $500,000 of gain on an annual basis would significantly shrink the activity undertaken by the TIC industry.
Finally, there is likely to be a significant “lock-up” effect that would come with the effective elimination of section 1031 for real property. Without the ability to defer gain, many taxpayers will simply decide not to sell, at least for a time. In many instances, this will prevent the acquisition of property by parties who would develop property to its highest and best use. And the implications are broader. For example, without the transfer of property, certain states and municipalities will not receive transfer taxes and recording fees in connection with the sale, and the property will not be revalued for property tax purposes by reference to the transfer value.
Opinion: Taxpayers generally have up to 180 days to complete a like-kind exchange. The proposal’s effective date appears to indicate that taxpayers who engage in the first part of a like-kind exchange during 2021 may need to complete the second part of the like-kind exchange prior to December 31, 2021, even if the 180-day period has not lapsed. Presumably this means that if a taxpayer were to engage in a deferred exchange that straddles two taxable years, the gain would be triggered in the first taxable year when the relinquished property is transferred rather than the second year when the exchange is completed. This treatment would represent a change from current law, since under current law gain recognized in a deferred exchange is determined under the installment method.[6]
Permanent implementation of Section 461(I) Excess Business Loss Limitation for Individuals
The 2017 federal tax reform provisions implemented Section 461(l), limiting the extent to which business losses in excess of a certain threshold for non-corporate taxpayers may be used to offset other income. The amount in excess of the limit would be disallowed in the current year but converted to a net operating loss that could be used in the next year subject to net operating loss carryforward and carryback limitations. In effect, this rule limits the ability of non-C corporation taxpayers to deduct (in the year recognized) business losses in excess of a threshold amount (e.g., $500,000 for married individuals filing jointly, adjusted for inflation) against other income, like wages and investment income.
The business loss limitation currently in effect applies for tax years beginning after December 31, 2020 and before January 1, 2027. The Administration’s proposal would make permanent the Section 461(l) excess business loss limitation on non-corporate taxpayers for tax years beginning after December 31, 2026.
Opinion: The 2017 federal tax reform utilized section 461(l) as a partial offset to the Section 199A passthrough deduction with both expiring on December 31, 2025, until Congress extended only the limitation through 2026 in legislation earlier this year. Biden’s current proposal, in a departure from his campaign proposals, does not limit Section 199A for the period during which it remains in effect.
Increase to IRS enforcement and operations support
Biden’s FY 2022 budget proposes a multi-year adjustment to the discretionary spending allocation for IRS enforcement and operations support. The proposal would provide funds targeting improvements and expansions in enforcement and compliance activities. Additional resources would be directed towards enforcement against taxpayers with income above $400,000.
The Green Book details Biden’s proposal to create a comprehensive financial account information reporting regime. Financial institutions would report data on financial accounts in an information return. The annual return would report gross inflows and outflows with a breakdown for physical cash, transactions with a foreign account, and transfers to and from another account with the same owner. Similar reporting requirements would apply to crypto asset exchanges and custodians.
Conclusion
While there is little good news in the proposals described above, there are certain proposals discussed during Biden’s campaign that were not included in the Green Book. For example, the Green Book proposes no phase out of the Qualified Business Income deduction under section 199A, and no cap on itemized deductions. This is not to say that these items will be off the table as Congress searches for revenue to offset spending provisions that are proposed.
The Green Book also does not include a proposal to repeal or modify the $10,000 aggregate limitation that was imposed by the TCJA on the itemized deduction for state and local income taxes, property taxes, and sales tax for taxable years 2018 through 2025. Modifying or repealing this limitation has been identified as a high priority issue by some members of Congress, and this issue could be raised during consideration of legislation later this year.
Just as guidance under TCJA has been largely completed, the Green Book is proposing significant changes to the tax system that again could force a re-thinking of decisions relevant to real estate. It may be necessary to reconsider structuring of real estate investments, the timing and method for disposing of assets, compensation arrangements regarding investment management for real estate, along with numerous other decisions. The Green Book represents only the recommendations of the Biden Administration, and it is not clear whether all or any of the provisions ultimately will be enacted into law in the form described here. But with the Democratic party in control of the White House and both legislative branches, and the revenue produced by these proposals intended as an offset to fund Democratic spending priorities, the Green Book is a document that should be taken seriously. Time will tell the ultimate fate of each of the Green Book proposals. In the meantime, it will be important to monitor the progress of negotiations around these proposals and recognize in planning the various outcomes that are possible.
[1] This has led to a significant amount of estate planning during 2021 because under the Administration’s current proposals, such transfers beginning in 2022 may be subject to income or capital gains taxes for the first time; a true phantom income event especially where illiquid assets are involved in such transfer.
[2] Other proposals have been introduced in Congress that would treat certain properties held in trust for an extended period of time as deemed transferred for purposes of triggering tax on appreciation related to such assets. See, e.g., H.R. 2286, 117th Cong. (2021) (property held in trust for 30 years without triggering a deemed sale upon gift or death is deemed transferred).
[3] For example, assume that A and B form a 50-50 partnership, with A contributing $100 and B contributing property with a basis of $0 and value of $1 million. Obviously, B has made a transfer of value to A in connection with the formation of this partnership, and the appreciation associated with that shifted value may be subject to tax under the proposal.
[4] A real estate professional is generally exempt from the 3.8 percent NIIT to the extent that they actively participate in a trade or business activity. If such an amendment were enacted, real estate professionals may cease to be exempt from the NIIT for gross income not subject to self-employment tax.
[5] Although light on details, the Green Book appears to follow the model for taxing carried interest that is embodied in the Carried Interest Fairness Act of 2021. Such rules in that Bill are very complex.
[6] Section 453(f)(6). Under current law if there is a net decrease in liabilities involving an exchange straddling two taxable years, gain is recognized in the first year under Rev. Rul. 2003-56.
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