American Household Plan and Actual Property Investments – Capital Good points and Transferred Pursuits – | Whitman Authorized Options, LLC

Most people have heard Aaron Copeland's "Fanfare for the Common Man". Copeland's Fanfare is the most famous of 18 fanfares commissioned in 1942 by Eugene Goossens, the conductor of the Cincinnati Symphony. Goossens & # 39; goal in commissioning these fanfares was to support the war effort.

Most fanfares had military themes such as fanfare for aviators and fanfare for the American soldier. Copeland did his best to find a title for his fanfare, however. He considered fanfare for the spirit of democracy and fanfare for the four freedoms (language, religion and freedom from need and fear). He chose fanfare for the common man because he believed it was the common man "who did all the dirty work of war and the army."

Goossens chose March 12, 1943 for the world premiere of Copeland's Fanfare. The date wasn't a coincidence. It was selected to coincide with the March 15th deadline for paying federal income tax.

The premiere of Fanfare for the Common Man near Tax Day paid tribute to the people's financial sacrifices to pay for the war effort. Goossens chose tax day because "the common man will pay his income tax two days later (if he has anything left to pay it with").

In 1943 that was an accurate statement. The United States had been at war for more than a year. Taxes had to be increased to meet these costs. The withholding of the payroll was new. So many taxpayers had overdue taxes from previous years, and March 15th was the day their overdue tax liability could increase further.

We are currently in another type of war for more than a year – a war on COVID-19. There have been sacrifices both for human life and financially. The government has allocated significant amounts to COVID-19 relief to help people and the economy survive the pandemic.

Taxpayers inevitably have to pay for COVID-19 relief. The question is what tax changes will be made to generate additional tax revenue. And since tax policy also affects taxpayer behavior, the country is likely to see a changing business and investment environment in response to higher taxes.

Less than a month ago, when I was re-evaluating real estate dispositions as part of the Biden tax plan, I outlined the expected tax proposals and their impact on real estate transactions. Since then, President Biden has announced the American Families Plan.

While the American Families Plan provides many benefits that are expected to help middle-class families, it also includes changes in tax law, presumably to pay for those benefits. This article is part of a series that discusses how the American Families Plan might affect real estate investments, and discusses long-term capital gains and interest income.

Long Term Capital Earnings Rate – Why Should Some Earnings Be Treated Different?

There are two ways an investor can owe taxes on investment property sales:

  • Appreciation or appreciation in value (i.e. the property is sold for more than what is invested in it) called "capital gains" and

  • "Recapture" of depreciation costs incurred by the investor in the ownership of the investment property. Although land cannot be depreciated, there may be buildings so there is a significant tax liability on the sale of the investment.

Tax law differentiates capital gains based on how long the investor owned the property. If the investor has owned the property for more than a year, it is a "long-term capital gain". Gains from real estate held for less time are known as "short-term capital gains".

Short-term capital gains are taxed at the same rates as regular income. However, long-term capital gains are currently taxed at lower rates. By taxing long-term capital gains at a lower rate, people have an incentive to save money and make investments.

Lower long-term capital gains rates can also be viewed as an attempt to adjust taxes to inflation. If someone buys a property for $ 100,000 and sells it for $ 150,000 six months after buying it, the cost of living has changed little between purchase and sale. So the profit of $ 50,000 reflects an increase in real value (inflation-adjusted face value) for the investor.

If an investor invested $ 100,000 in a property in March 2001, the consumer price index-adjusted equivalent would be $ 150,327.47 in March 2021. Selling the property for $ 150,000 would translate into a nominal 50 percent gain while keeping the real value of the investment essentially unchanged. Some would say the lower long-term capital gain rate would help offset such phantom changes in the asset.

Sponsorship remuneration through a transferred stake

Sponsors also benefit from long-term treatment of capital gains. One way that property sponsors make money by putting investments together is called a "transferred interest". To motivate sponsors to manage the investment well, they are entitled to a percentage of the profit when the property is sold. The sponsor will not receive their payment until the investment is successful. This is because the sponsor is usually only paid after the investors have received all of their money plus a guaranteed "preferred" rate of return that is similar to interest.

Since a property sponsor may never receive a dime from their transferred interest, they will have no value at the beginning of the investment. A carried forward interest can be viewed as a bet on the success of the investment. Once a gamble bet is made there is no more value until the bet is paid off.

Since the interest carried forward receives a zero tax base when purchasing the property, any amount the sponsor receives is a capital gain. If the property is held for three years (versus one year for investors), any payment the sponsor receives from its transferred interest is treated as a long-term capital gain.

The American family plan would eliminate long-term capital gains tax rates

The American Families Plan aims to eliminate long-term tax rates on investment income. Profits from the sale of assets would be taxed at the same rate regardless of whether the seller owned the property for six months or sixty years.

Eliminating the long-term capital gain rate is likely to slow the property market as it changes the economics of a property sale. Why sell a good performing asset when you know you owe a huge tax burden? The result can be lower inventory levels in the investment real estate market. It could become a “seller's market” as prices rise.

Real estate investors often rate the success of their investment based on the internal rate of return (IRR). The IRR is a discount rate (interest rate) at which the present value of the cash flows from the investment is zero.

Since the IRR is based on the time value of money, the timing of the cash flow from the sale affects the IRR significantly. If a sale is deferred, the IRR goes down. If investors hold assets for long periods of time to delay realizing a taxable gain, they will need to increase current cash flow to get the expected IRR investors.

There are two ways to increase current cash flow: increase income or decrease expenses. Because rental rates are influenced by supply and demand, there is a limit to how much an owner can raise rental rates. It may be easier for owners to cut costs by cutting amenities and postponing maintenance.

In addition, investments are often made at the time of purchase (when the investor has new funding) or in preparation for disposal (in the hope of a higher selling price). Therefore, increasing the holding period of assets is likely to reduce capital improvements in real estate, which will affect the condition of the real estate.

Long-term capital gains rates and interest income

While the American Families Plan suggests "permanently eliminating carried-over interest," it is technically incorrect. Sponsors are likely to continue to be able to receive transferred interests. However, by eliminating long-term capital gains rates, earnings from interest carried forward would be treated in the same way as any other sponsorship income.

Taxing payments on a sponsor's interest income as regular income is likely to change the way sponsors make real estate investments. Without a long-term treatment of capital gains and less incentive for investors to sell the transferred interest and trigger payments, sponsors' fee structures could change.

If sponsors are not deterred from waiting for the property to be sold in order to receive their compensation, they can increase annual asset management fees or charge higher upfront fees in lieu of a carryover interest. And without a sustained interest, sponsors can concentrate less on the long-term increase in property value. Instead, the focus may be on the return on the investment.

A real estate investment held primarily for current income rather than long-term gains can be managed differently. Because maintenance and capital expenditures can reduce the cash available for distribution as investor income, there is less incentive for owners not to make repairs or improvements.

Changing real estate investment strategies

Although taxes make money for the government, tax policies also encourage (and negatively affect) taxpayers' behavior. The studies differ on whether the significant increase in the American Families Plan would increase total tax revenue after taking into account the decrease in real estate sales. However, the Tax Policy Center's study, which compares historical capital gains rates with transaction volume, supports the idea that investors change their behavior based on long-term capital gains tax rates.

Therefore, when long-term capital gains rates are eliminated, sponsors and investors are likely to adjust their investment strategies to offset the increased taxes. Some of these customizations can include:

  • Increased use of installment sales and seller financing to distribute the sales proceeds over several tax years

  • Reduced sponsor investments in the long-term success of real assets by reducing or eliminating the transferred shares in favor of annual fee income

  • Longer hold times

  • Increased rents

  • Strategic deferral of maintenance

  • Less capital projects

  • Reduced real estate transaction volume

Real estate is currently an attractive investment as it can provide statutory tax protection for income through depreciation and a reduced tax rate for long-term capital gains. Investing in real estate in the US allows investors to invest locally too. Because real estate cannot move, the real estate and jobs it maintains are local and cannot be outsourced abroad.

If the capital gains tax rate is abolished, investors will have little incentive to invest in long-term investments in general, and real estate in particular. It is possible that potential investors will spend their money instead and fuel economic growth. It is also possible that you choose other systems that may contain an international component.

Most sponsor real estate profiles do not include investor income tax analysis. This makes sense because each investor's tax situation is unique. Until investors know how their real estate investment income will be taxed, they should create pro formas showing multiple scenarios and assess the potential tax liability for each scenario.

This series draws on Elizabeth Whitman's background and passion for classical music to illustrate creative solutions to legal challenges facing businesses and real estate investors.