Usually, when there is a change in the President and administration there are changes to many things, including tax policy. The Biden administration is no different and has proposed many changes in The American Families Plan. This plan would overhaul many longstanding preferential tax provisions for high net-worth individuals. While The American Families Plan had many changes to individual and business tax code, this article focuses on the changes to the capital gains tax rates, 1031 tax-free exchanges, and rules for step-up in basis at death. We will also highlight how Opportunity Zones would be even more beneficial if these changes are enacted.
The Biden administration has proposed several changes to the tax code that will significantly increase the tax liability for high net-worth individuals. Below we outline the current tax laws and what is being proposed as part of the new legislation.
Proposed Tax Changes in The American Families plan
Marginal Tax Rate Increase
The Tax Cuts and Jobs Act lowered the top individual tax rate from 39.6% to 37% for tax years 2018 to 2025. The Biden administration has proposed to increase the marginal tax rate back to 39.6% starting in the tax year 2022 for individuals and head of household filers making over $452,700 and for married joint filers making over $509,300.
Long-Term Capital Gains Rate Increase
Currently, long-term capital gains on assets held for at least one year are taxed at a preferential maximum Federal rate of 20% plus a 3.8% surtax on net investment income, so a total of 23.8%. Under President Biden’s proposed plan, capital gains for all taxpayers with income over $1 million would be taxed as ordinary income. This means that if this legislation gets enacted there would be no preferential treatment for long-term capital gains and the Federal tax rate for capital gains would be the same as ordinary income tax rates, which is 43.4% (39.6% + 3.8%).
Note: It is currently unknown if an individual with over $1 million in income would trigger all capital gains to be taxed at the ordinary income tax rate, or if only gains above $1 million would be taxed at the proposed rate.
Limit Like-Kind Exchanges to $500,000 of Deferred Capital Gains
Like-kind exchanges allow for the sale of real property and the acquisition of similar property without generating a capital gains tax liability. There is currently not a cap on the amount of gain that could be deferred through a like-kind exchange. The new legislation has proposed limiting the amount of capital gain that could be deferred to $500,000. This could create a very large tax bill on property that has been held for many years or property that has continuously been deferring taxes with multiple 1031 exchanges.
Remove the Step-Up in Basis Upon Death
In the current tax law, if a person passes away and has investments or real estate with unrealized gain, the person’s heirs would receive a step-up in basis to the fair market value and would not be taxed. The American Families Plan would tax inherited unrealized gains above $1 million for individuals and $2 million for married joint filers.
Note: The Biden administration has stated several types of businesses would be excluded under the current proposal from this tax provision, however it is unclear which businesses would be excluded and how this tax would be implemented at this time. Although the details are currently unknown, the framework being discussed would be a large change from the current law that could impact many taxpayers.
Summary of Proposed Tax Changes in the American Families Plan
- Income over $452,700 for single and head of household filers and $509,300 for married joint filers will see the marginal ordinary income tax rate increase from 37% to 39.6%
- Tax long-term capital gains at the ordinary income tax rates for taxpayers with income above $1 million. The tax rate for income over $1 million will be increased from 23.8% to 43.4%
- Limit like-kind exchanges to $500,000 in deferred capital gains. All gains over $500,000 would be taxed at capital gains rates.
- Tax unrealized gains upon death for gains above $1 million for individuals and $2 million for married joint filers.
Qualified Opportunity Zone Funds
Qualified Opportunity Zone legislation was passed as part of the Tax Cuts and Jobs Act in 2017. The goal of the Opportunity Zones is to incentivize investment in traditionally undercapitalized or economically distressed communities.
The Biden administration has not proposed any changes to the tax incentives provided by Opportunity Zones. They have discussed additional reporting requirements for fund operators, but this will not affect investors. Below, we outline three tax incentives for investing realized capital gains into Opportunity Zones.
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Defer Realized Capital Gains
Investing realized capital gains into a Qualified Opportunity Zone Fund allows an investor to defer the capital gains tax until December 31, 2026, or until the Opportunity Zone investment is disposed, whichever occurs first. The full amount of proceeds received from the sale does not need to be invested, only the capital gains. This allows investors to invest into a fund and potentially earn money on their investments while deferring their tax obligation.
Step-Up in Basis of Original Investment
An investor who holds their investment in a Qualified Opportunity Zone Fund for at least 5 years will receive a 10% step-up in basis. For example, if a person invests $500,000 of capital gains into a Qualified Opportunity Zone Fund and holds the investment for 5 years, the investor will receive a $50,000 step-up in basis, and will only be required to pay taxes on $450,000 of the initial capital gains.
Note: The investment must be held for at least 5 years before December 31, 2026, to qualify for the 10% step-up in basis. This means that an investment must be made on or before December 31, 2021, to qualify for the 10% step-up in basis.
Permanent Exclusion Capital Gain
Once an investment in a Qualified Opportunity Zone Fund is held for at least 10 years, investors do not need to pay taxes on any capital gains produced through their initial investment in the fund. For example, if a person invests $500,000 into a Qualified Opportunity Zone Fund, holds the investment for at least 10 years, and sells the investment for $1.5 million, there is no tax due on the $1 million of appreciation. The basis in the investment is stepped up to the sales price, which produces no capital gain income.
Increase Benefits of Opportunity Zones Under the American Families Plan
If everything the Biden administration wants in The American Families Plan is enacted, it will make Opportunity Zone Funds even more attractive. There will be no preferential tax rate on capital gains, meaning investors will want to find ways to shield those gains from tax. A major way to do this previously was 1031 exchanges, but these could be severely limited in the future with the $500,000 cap the Biden administration is proposing. There is currently no cap on the amount of capital gains that can be placed into an Opportunity Zone Fund and these funds could be one of the few places to invest large capital gains while deferring tax.
Click here to listen to former HUD Secretary, Ben Carson, and Caliber Co-Founder & CEO, Chris Loeffler discuss Qualified Opportunity Zones, their impact on overlooked American communities and the potential tax benefits investors can claim by investing in them.
Summary of Qualified Opportunity Zone Funds
- The Opportunity Zone allows investors to defer capital gains tax until December 31, 2026, or until the investment is disposed.
- If an asset is held for at least 5 years, an investors’ basis in the original investment will increase by 10%.
- For investments held for at least 10 years, investors will not pay taxes on any capital gains produced through their investment.
- Opportunity Zone Funds will be an even more attractive way to potentially defer and exclude capital gains if the changes from The American Families Plan are enacted.
To learn more about Opportunity Zone investing, contact us at firstname.lastname@example.org.