As the presidential election appears to be concluded, commercial real estate investors are now strategizing for the future impacts of new taxation policies under a different administration. It is worth prefacing this article with the fact that these changes / proposals are all preliminary at this point, as there are many factors that will ultimately determine whether or not these become a reality. That being said, it can greatly benefit investors to be proactive in re-evaluating their investment strategies under increased taxation policies.
There are three primary proposed changes to the tax law that would affect CRE investors:
- Raising capital gains from 20% to ordinary income tax rate of 39%
- Elimination or substantial reduction of tax-free estate transfer upon death
- Elimination of 1031 tax-deferred exchanges
The most probable and immediate implication would be raising the capital gains tax rate to an ordinary tax rate level, which would substantially increase taxes for high earners. On a sale with a gain of $1,000,000, for example, the federal tax burden would jump from approximately $200,000 to $400,000. This impact could likely change investor behavior to hold on to assets, especially those where the investor’s basis is low compared to the current market value. In these cases, it might make more sense to put a longer-term debt piece on the asset to benefit from the cash flow and potentially take some dollars out tax-free. If you’re among those that think long-term interest rates will be low for a while, this could be the better economic strategy by a long shot.
CRE investors seeking to build generational wealth are also strategizing on what to do if the estate transfer exemption is eliminated or reduced. The current tax law that expires in approximately 4 years allows an investor to gift up to ~$11,500,000 (per individual) in a tax-free exemption upon death. The Biden administration is proposing to reduce it or eliminate it altogether, and this could be retroactive to 2021 or commence in 2022. There is also some potential risk of changing the ability to step up an investor’s basis on estate-included assets. Similar to the strategies around capital gains, a solution to this could be refinancing with additional tax-free loan proceeds from long-term debt.
The third potential change regarding 1031 exchanges has not yet become a widely-discussed reality, and CRE investors hope that it stays that way. There have been hypothetical discussions to change this tax-deferral method, which would have drastic trickle-down effects on the real estate market. Even in the current pandemic-ridden sales market where acquisition activity has been minimal the past 9 months, the majority of transaction activity has come from motivated buyers with tax deferred exchanges. If and when this becomes a more realistic initiative, it will be important to adjust investment strategies accordingly.
The effects of these modified tax policies will significantly affect the CRE market and transaction volume could be significantly lower if sellers are challenged with a looming tax burden and can’t find suitable alternative investments at a more attractive after-tax return. As a result, refinance transaction volume may easily outpace acquisition financing in 2021.
Insurance companies are ideal lenders for investors that want long term debt to achieve a combination of cash flow, wealth accumulation, and current or future generational estate tax planning. Although banks are more frequently quoting permanent and non-recourse loans in today’s environment, their standard re-margining provisions (LTV stipulations for future appraisals), on-going loan covenants, and recourse components are not ideal for estate planning purposes.
Most often, insurance companies offer the best blend of non-recourse debt with estate planning that can be customized and tailored to the borrower’s future objectives. They offer the lowest rates with the longest fixed-rate terms with some at 30+ years fully amortizing for non-recourse loans. Insurance companies understand their borrower clients’ objectives and they’re flexible to craft specific language in the loan documents for key principals to replace others in the future, as an example.
Proactive investors are already re-evaluating strategies with their tax attorneys, estate planners and mortgage bankers to be able to react quickly before modified tax policies are potentially enacted. These steps will help in determining the ideal timing to transact and the best financing solutions on deal-by-deal basis.