What Will a Retrospective Capital Gains Tax Mean for Investors?

The Biden administration has released its “Green Book” for 2022. Included for consideration by Congress are several proposed tax changes that will have severe consequences for real estate investors if passed. Specifically, the proposals of concern are:

  • A retroactive capital gains increase
  • Changes to or eradication of the estate step-up in basis
  • Changes to or eradication of the 1031 exchange

But the administration isn’t targeting real estate investors exclusively. The budget package includes proposals to increase the top tax rate to 39.6 percent, levying a 10 percent surtax on the ultra-wealthy, and possibly a 2.5 percent one-time wealth tax and ongoing 2 percent to 3 percent annual wealth tax. Even corporations aren’t exempt—Congress will be looking at increasing corporate tax rates from 21 percent to 28 percent.

A Retroactive Capital Gains Tax Increase

Currently, the top capital gain tax rate is 23.8 percent for gains realized on assets held longer than a year. Biden plans to increase this to 43.4 percent for households earning more than $1 million. But additionally, he wants this implemented retrospectively to April 2021. And this is in addition to a “stepped-up basis” to tax capital gains over a $1 million exemption at death.  

Together with state capital gains taxes, the proposals would make American capital gains tax the highest in the industrialized world, surpassing even socialist countries like Denmark and France. And if taken as currently proposed, they could potentially tax ordinary individuals who have structured their retirement income on real estate investments as though they are millionaires. That’s according to a Wall Street Journal article that shared how a Kentucky man earning only $75,000 annually will have his savings halved when he’s taxed on the proceeds of the five apartment buildings he bought and renovated to support his retirement.

Effects of Eliminating the 1031 Exchange

Currently, a 1031 exchange allows real estate investors to defer gains on the sale of an investment property if they buy another similar property. It allows investors to realize gains on money that would otherwise have been paid over in tax and significantly improves long-term ROI. And at the time of death, the asset is “stepped up” to the fair-market value for heirs, meaning they won’t pay any capital gains tax if they sell the property.

Biden proposes that individuals defer taxes on gains of up to $500,000 and married couples up to $1 million. Additionally, deferred taxes on capital gains won’t be “forgiven” on death. So, beneficiaries will pay any deferred taxes in addition to taxes on additional gains when selling an inherited property.

However, any 1031 changes, if they pass, won’t be applied retroactively. So, if you have a property that you expect will realize gains over the proposed allowances, now might be a good time to sell. But remember, both sides of the transaction will need to be completed before December 31—the sale of your current property and the purchase of the replacement.

Reason for Investors to Hope

While it’s a good idea to plan, keep in mind that these changes are merely proposals at this stage—they must still get through Congress. (Although they are being dealt with via the reconciliation process, which means they can be passed with 50 votes and won’t be subject to filibusters.) However, it’s by no means a sure thing they’ll pass.

For starters, analysts at Penn-Wharton predict Biden’s capital gains changes will lower federal revenue by $33 billion instead of raising it. If the Congressional Budget Office comes to the same conclusion, it’s unlikely the changes will be made. Congress may also be sensitive to the small businesses and individuals who are already struggling amid the pandemic and won’t be able to handle retroactive taxes.

The whole reason for a retrospective tax is that, historically, capital gains tax increases prompt a rush of sales that result in a one-off spike in tax revenue at the old tax rates and lower collections for years afterward. But it’s not at all clear that retroactive taxes are, in fact, constitutional. The constitution bans retroactive criminal laws on the basis that citizens can’t reasonably be expected to comply with the law before it’s made and must be given a due warning to adjust their behavior. Thus, interested parties may challenge the constitutionality of Biden’s bill were it to pass.

Then, retroactive taxes deny taxpayers the ability to plan their affairs, thereby undermining the fundamental requirements for taxation to be transparent and stable. They also undermine the perceived fairness of the legal system and, therefore, the respect of the public.

Concerning the possible reduction or repeal of Section 1031 benefits, separate Ernst & Young and Ling-Petrova studies found the move would bring about several “unintended consequences” that could outweigh any short-term gains and act at cross purposes to tax goals. To summarize the findings, eliminating Section 1031 will:

  • Discourage investment
  • Shrink the economy
  • Lower federal revenue

While it’s unlikely the Democrats’ proposed Budget 2022 will pass without substantial amendments, the proposals do serve the purpose of reminding investors not to be complacent. Understanding the key drivers of your ROI is critical to avoid falling foul of changing circumstances that may upend your plans.