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2025 Budget Proposal: How It Affects Real Estate Investors

Will President Biden's Proposed Budget for 2025 Affect Real Estate Investors?

President Joe Biden recently announced his 2025 Budget Proposal. There are many points to consider that will change the average American’s wallet. However, none are as potentially catastrophic for building wealth as the following three points we will cover today. You won’t want to miss this read if you’re going to create generational wealth (like us real estate investors).

The bottom line is that we all want to increase our wealth. It’s not just real estate investors who subscribe to the American dream. How we come upon this money is different for all of us. Some work second jobs or side hustles, and many resort to investing. We soon realize that wealth doesn’t come just from making money but also from keeping it. That is why the United States Tax Code and any proposed changes are always important to pay attention to when you are an investor.

Changes in Budget Proposal

As I have been saying, President Biden has outlined several changes in his 2025 Budget Proposal that could significantly impact real estate investors.

Up until now, the IRS and real estate investors have had an understanding of their roles in our economy. As investors, we take huge risks in investing in real estate and offering it up to renters without guaranteeing that we will make money or land a good tenant.

In return, the government tax code offers incentives to investors by allowing deferred taxes through a 1031 exchange, a flat rate capital gains tax, and even the ability to maximize our hard work by allowing these assets to pass on tax-free to our children through a step-up basis.

The Biden administration wants to cut the trillion-dollar deficit by minimizing or removing many of these incentives offered to real estate investors. Whether they pass or not remains to be seen. Let’s look at the proposed three investor tax changes and how they will affect investors and the real estate market in general.

Capital Gains Tax

First up is President Biden’s proposal to increase the capital gains tax rate for high-income earners. Capital gains taxes apply to any profit realized on an asset. For our blog, we will be speaking about real estate assets.

When you sell a property at a profit, the government taxes that profit at specific rates. The rate depends on which bracket you fall into once you add all your income. Taxable income includes your wages or any 1099 income and the money you made on selling your real estate.

If you held the property for less than one year, you are subject to ordinary income tax rates ranging from 10% to 37%. If you own the property for over a year, you are taxed at long-term capital tax rates of 0%, 15%, and 20%. There is also an additional 3.8% net investment income tax that is applicable once your income exceeds $200,000.

Under this new tax proposal, both short-term and long-term rates will increase. While the Biden Administration says it will only affect high-income earners, I doubt it.

Currently, the highest rate you can be taxed at is 37%. To reach that rate, you need a combined wage and capital gains income of at least $609k for single filers and $731k for married couples.

Part of President Biden’s proposal includes increasing this 37% to 39.6%, which was the rate before President Trump passed the Tax Cut and Jobs Act of 2017. This is set to expire at the end of 2025, making it more likely for this part of the proposal to pass.

The second part is the change in the tax bracket to which this new rate applies. This 39.6% does not begin at $609k like the 37%. Under the new proposal, this will start at $400k and $450k, respectively. I also expect to see a change in the rest of these brackets.

As these brackets adjust to accommodate for the $331,000 difference between what is now and what is proposed, the rates for just about everyone, not just the wealthy, will likely shift up to the following tax brackets.

The second part of that is the change for long-term capital gains. In this case, if you held a property for longer than a year and had a taxable income of over $1M, then instead of paying the flat 20% on that capital gain, you would now be subject to the highest ordinary income tax rate, which I just told you would be raised to 39.6%. But that is not all.

I mentioned earlier that an additional 3.8% net investment income tax is owed by anyone breaching a modified adjusted gross income of $200,000 for single filers and $250,000 for married couples. So, if your income, including any investment income, is above these, you are also subject to this 3.8%. Only the proposal is now to increase this to 5%. So, if you make over that $1M income, you are paying 44.6% — almost half of your taxes! And this does not include your state’s income tax.

1031 Exchanges

President Biden’s proposal will abolish the 1031 Exchange. The 1031 exchanges have been around in some form or another for 100+ years. They are one of the best tools for accelerating your investment growth.

Doing a 1031 exchange will allow a real estate investor to avoid that 44.6% tax by reinvesting the entire sale proceeds into another property. Since there is no limit to the number of 1031 exchanges, you can continue to roll from one property to another. Going from a single-family home to a duplex or fourplex to a 10-unit apartment building is expected. You can listen to many real estate investors who will tell you they didn’t start at the top but at the bottom.

With the elimination of the 1031 exchange, anyone selling a property to buy another one would have much less money to reinvest. If you had to do that every time you wanted to improve your investment, there would be a limit to how much you would like to grow. At some point, the amount of money you would pay in tax would stop you from continuing to invest. You would instead just keep what you had and pass it on to your children. Or would you?

Step-Up Basis

That brings me to the proposed change to a step-up basis. President Biden proposes to limit the step-up basis option to assets less than $5M for singles and $10M for married couples. What is a step-up basis, and why should that matter to you?

A step-up basis is an exciting perk. Assets that we accumulate throughout our life will increase in value. As mentioned earlier, you must pay Uncle Sam anytime you sell one of these assets for a profit. It applies to rental properties and personal assets like your home, stocks, and retirement accounts.

The tax code gives you some provisions to avoid these gains while living. For instance, you get a 1031 exchange for investment properties or a home sales tax exclusion for your residence. When you die, they give your heirs the perk of a step-up basis.

When they inherit assets from you, those assets are automatically brought up to the current market value for taxation. If your heirs decided to sell any of those assets, they would not be subject to any capital gains tax. The value at which they inherited the property and the market value they could fetch if they sold it are the same: no gain equals no tax.

In most states, this only happens upon the transfer to an heir once. In Idaho, you can do this twice. Idaho is a community property state with rights of survivorship. This means that when you die, your spouse automatically inherits all your property. At that point, Idaho allows your spouse to get a step-up basis on those assets. Then, when your spouse dies, your heirs — most likely your children — also inherit that property on a stepped-up basis.

Here is the nuance with this proposed change: If the assets are under $5M or $10M combined, then you can continue to pass these assets down tax-free. If they have a higher value, the portion above that limit will be taxed at capital gains rates.

You might think that $5M is quite a bit, but we only consider real estate in this video. This limit applies to all your assets, like art, valuable heirlooms, stocks, and other collections. You might be over that threshold when it is accounted for. That’s especially true if you are an investor trying to pass down wealth to your children. This $5M might not go very far at the end of your life.

Final Thoughts

Now, other tax changes are being proposed. But for us small investors just getting started, these three have the potential to limit our growth opportunities. I’m interested to hear what you think the effects of these changes will be. Will any of them pass? If you are an investor, do you see some advantages to any of these? Will this affect the way you invest in the future? Contact us today.

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