On March 28, 2022, the U.S. Department of the Treasury released its General Explanations of the Administration’s Fiscal Year 2023 Revenue Proposals (here), also known as the “Greenbook.” The Greenbook provides detail regarding the Biden Administration’s proposals to increase taxes and reduce tax benefits applicable to real estate activities.
It remains to be seen whether these proposals will be enacted into law. If they are enacted, they may have significant effects on real estate investors and developers.
Proposed Revenue Raisers Potentially Affecting Real Estate Industry
Proposed revenue raisers detailed in the Greenbook of particular interest to real estate investors and developers include:
- Increasing the top federal income tax rate on ordinary income to 39.6% for single taxpayers with taxable income greater than $400,000 and for married couples filing jointly with taxable income greater than $450,000, effective for tax years beginning after December 31, 2022.
- Increasing the top federal income tax rate on capital gains and qualified dividends to the maximum tax rate applicable to ordinary income (proposed to be 39.6%plus 3.8% Medicare tax) for taxpayers with taxable income greater than $1 million ($500,000 for married taxpayers filing separate returns).
- Treating as ordinary income a partner’s share of income and gain from, and such partner’s gain from the disposition of, “carried interests” in an investment partnership for which such partner provides services, if the partner’s taxable income (from all sources) exceeds $400,000.
- Eliminating tax-deferred Section 1031 like-kind exchange treatment for capital gains from like-kind exchanges in excess of $500,000 ($1 million in the case of married taxpayers filing joint returns) per year.
- Eliminating the ability to step-up the basis of property upon death without paying income tax by subjecting the unrealized gain in such property to tax upon death or earlier gift, subject to a $5 million per person lifetime exclusion from recognition of unrealized capital gains, a $250,000 per person ($500,000 per couple) exclusion for capital gain on a principal residence and exclusions for transfers to surviving spouses and to charities.
- Requiring ordinary income treatment for depreciation recapture on sales or other taxable dispositions of depreciable real property.
- Imposing a 20% minimum tax on taxpayers with wealth (i.e., assets in excess of liabilities) greater than $100 million, the purpose of which is to ensure that the minimum tax is paid not only on realized taxable income, but also on unrealized ordinary income and capital gains.
Certain of these are discussed in more detail below.
The Greenbook also includes details for increased IRS enforcement discussed in more detail here.
Elimination of Lower Tax Rates Applicable to Long-Term Capital Gains of High-Income Individuals
The Biden Administration proposals detailed in the Greenbook would increase the top federal income tax rate on long-term capital gains from real estate and all other investments from 20% (plus 3.8% Medicare tax) to the maximum tax rate applicable to ordinary income (proposed to be 39.6% 37.0% (plus 3.8% Medicare tax) for taxpayers with taxable income greater than $1 million ($500,000 for married taxpayers filing separate returns) per year, as indexed for inflation after 2023. The increased rates would be effective for gain required to be recognized and dividends received on or after the date of enactment.
The proposal would also similarly increase the tax rate applicable to qualified dividend income. However, nothing is included in the proposal (at least at this point) that would eliminate the 20% Section 199A deduction applicable to REIT dividends.
Taxation of Carried Interests
The Biden Administration proposals detailed in the Greenbook would generally treat as ordinary income, subject to both tax at ordinary income rates and self-employment tax, a partner’s share of income and gain from an investment partnership for which such partner provides services (an “ISPI”), if the partner’s taxable income (from all sources) exceeds $400,000. Gain recognized on the disposition of an ISPI also would be treated as ordinary income if the partner’s taxable income exceeds such threshold. The proposal further provides as follows:
- 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 50% 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.
- The proposal would not apply to income or gain from “qualified capital interests” for which the partner contributes “invested capital” to the partnership. Invested capital is generally money or other property, but would 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). A qualified capital interest is generally one where (a) the partnership allocations to the invested capital are 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.
- Anti-abuse rules would be included to prevent avoidance of the proposal’s application through the use of compensatory arrangements other than partnership interests, including rules which would apply ordinary income recharacterization treatment to convertible or contingent debt, an option, or any derivative instrument held by a person in any entity for whom such person performs services.
- Mechanisms may be included “to assure the proper amount of income recharacterization where the business has goodwill or other assets unrelated to the services of the ISPI holder.”
The proposal would be effective for taxable years beginning after December 31, 2022 and would repeal Section 1061 for taxpayers with taxable income (from all sources) in excess of $400,000.
Elimination of Section 1031 Like-Kind Exchange Treatment
For almost a hundred years, Section 1031 like-kind exchange treatment has been a valuable tool for allowing real estate investors to roll the proceeds of real estate sales into purchases of other real estate without paying capital gains tax on the profits. This deferral process can theoretically continue indefinitely, by the investor either continuing to hold the property or engaging in one or more subsequent like-kind exchanges, until the investor’s death. At that time, the heirs’ tax basis in the real property can (under current law) be stepped-up to fair market value without triggering any income tax.
The Biden Administration proposals detailed in the Greenbook would eliminate tax-deferred Section 1031 like-kind exchange treatment for capital gains from like-kind exchanges in excess $500,000 ($1 million for married individuals filing a joint return) per year, effective for exchanges completed in taxable years beginning after December 31, 2022.
Closing the “Stepped-Up Basis Loophole” for Property Upon Death
As discussed in the preceding section, current law provides that, when a person who holds appreciated real estate or other appreciated assets dies, heirs who inherit those assets are permitted to step-up the tax basis of the assets to their then fair market value, without triggering any income tax. The Biden Administration proposals detailed in the Greenbook would change this result by subjecting to income tax the unrealized gains (those that have never been previously taxed) inherent in appreciated property held by the taxpayer at the time of death or, if earlier, at the time of gift.
Certain exclusions would apply, including, among others, a $5 million per person lifetime exclusion (indexed for inflation after 2022) from recognition of unrealized capital gains, a $250,000 exclusion per person ($500,000 per couple) for capital gain on a principal residence and exclusions for transfers to surviving spouses and to charities. Additionally, deferral elections would be provided with respect to (i) recognition of unrealized appreciation on family-owned and -operated businesses and (ii) the period over which the tax due on illiquid appreciated assets is payable.
This proposal would be effective for gains on property transferred by gift, and on property owned by decedents dying, after December 31, 2022.
Elimination of Capital Gain Treatment for Depreciation Recapture on Real Property.
Current law provides for a special capital gains tax rate of 25% (28.8% including Medicare tax) on the gain recognized on a sale or other taxable disposition of real property to the extent of the depreciation deductions previously allowable on such real property (the “depreciation recapture amount”). The Biden Administration proposals detailed in the Greenbook would treat this depreciation recapture amount as ordinary income, resulting in tax at ordinary income rates (i.e., 39.6% under the proposals, plus 3.8% Medicare tax) for noncorporate taxpayers with adjusted gross income of $400,000 or more ($200,000 or more for married individuals filing separate returns).
This proposal would be effective for depreciation deductions taken on real property in taxable years beginning after December 31, 2022, and sales and other taxable dispositions of depreciable real property completed in taxable years beginning after December 31, 2022.
Minimum Tax on Unrealized Gains of Taxpayers with Net Worth Exceeding $100 Million
Under the Biden Administration proposals detailed in the Greenbook, taxpayers with wealth (i.e., assets in excess of liabilities) greater than $100 million would be subject to a 20% minimum tax, the purpose of which is to ensure that the minimum tax is paid not only on realized taxable income, but also on unrealized ordinary income and capital gains. The 20% minimum tax rate would be phased in for taxpayers with wealth greater than $100 million but less than $200 million. The proposal further provides as follows:
- Payments of this minimum tax would be treated as a prepayment available to be credited against subsequent taxes on realized capital gains to avoid taxing the same amount of gain more than once.
- Taxpayers could choose to pay the first year of minimum tax liability in nine equal, annual installments. For subsequent years, taxpayers could choose to pay the minimum tax imposed for those years in five equal, annual installments.
- Taxpayers whose tradeable assets (held directly or indirectly) make up less than 20 percent of their wealth (i.e., illiquid taxpayers) may elect to include only unrealized gain in tradeable assets in the calculation of their minimum tax liability.However, taxpayers making this election would be subject to a deferral charge on the tax incurred when gain is actually realized on non-tradeable assets. The proposal indicates that this deferral charge would not exceed 10% of unrealized gains.The proposals detailed in the Greenbook do not define “tradeable” or “non-tradeable” assets, but provide publicly traded stock as an example of a tradeable asset.
- Taxpayers with wealth greater than the threshold would be subject to detailed annual reporting requirements and valuation requirements regarding their assets and liabilities.However, taxpayers would not have to obtain annual, market valuations of non-tradeable assets. Instead, non-tradeable assets would be valued using the greater of the original or adjusted cost basis, the last valuation event from investment, borrowing, or financial statements, or other methods approved by the IRS, and such valuations would be deemed to increase by a “conservative” floating annual return (the five-year Treasury rate plus two percentage points) in between valuations.
This proposal would be effective for tax years beginning after December 31, 2022.
We will continue to monitor developments and will provide further updates as more details are released. In the meantime, Baker Botts would be pleased to assist you in your analysis of these proposals.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm whose lawyers practice throughout a network of offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy, technology and life sciences sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.