New tax changes and their effects on investment real estate

When it comes to investment real estate, many factors including tax law changes come into play for the individual investor.  Changes to the long-term capital gains tax rate and the tax-free exchange laws could greatly affect the real estate economy, with regard not only to investors but also affiliated professions; such as appraisers, titles companies, surveyors and lenders.

To understand how changes in these tax laws could affect investment real estate, it’s necessary to understand the law as it is currently. The long-term capital gains tax rate applies to the sale of real estate investment assets held longer than a year. Current rates are zero percent, 15 percent, and 20 percent, depending on the investor’s income. 

Currently, if an investor is single and makes up to $40,400 a year, a zero percent tax rate would apply to the capital gain if the investor were to sell, for example, an apartment building owned for three years. Those in the $40,401 – $441,450 a year range would pay 15 percent, and those making more than $441,450 would pay 20 percent plus the 2.5 percent healthcare tax and other state taxes.

How would a change to the long-term capital gains tax rate affect investment real estate? If these tax rates were lowered, then each income classification would pay less tax on their capital gains, and if the tax rates were raised, each income classification would pay more on their capital gains.

A tax-free exchange is selling a property at a profit and then reinvesting that money into another property. In this circumstance, the investor can differ any capital gains tax owed until the next property is sold. If the investor continues to sell and reinvest, i.e. exchange, then capital gains taxes can be deferred until such time as he sells the property and does not reinvest. These favorable tax laws are meant to encourage investors to invest in long term real estate ventures and to continue to reinvest those money and profits over and over.  

The current tax-free exchange law states that if an investor sells an apartment building and reinvests the capital gain by buying an office building, they will be allowed to defer any tax on that capital gain. The current Biden tax proposal will eliminate all tax free exchanges and cause investors to pay tax at the normal tax rates of ordinary income, which would double the amount of taxes they would owe. History has proven, over and over, that when long term capital gains rates are increased investors are no longer willing to sell. The result is fewer taxes are received by the federal government. Every single time long term capital gains rate has increased, the net effect has been fewer tax dollars paid and received. This also has a devastating effect on related professions who make income when properties are sold; such as surveyors, appraisers, titles companies and lenders. . 

Randy McMillian*, owner of NAI 1st Valley, notes that, based on his experience in the industry, eliminating the tax-free exchange law would discourage investors and result in a drastic decline in the investment real estate economy. Raising the long-term capital gains tax rate would lead to the same result. Anticipation of these changes are prompting many investors that were originally planning to sell investment property in the next few years to sell now in order to not be penalized by Biden’s proposed changes. 

In a nutshell: It’s a good time to buy investment property, because there is a larger inventory of properties for sale by investors who are trying to sell properties before these new tax laws take effect. It’s unusual when it’s a good time to both buy and sell, but this is one of those unreal times. 

*Randy McMillan of 1st Valley reality was interviewed for this article. He has 42 years experience in buying and selling commercial properties. Randy both has the CCIM and SIOR accredited designation. You can contact Randy for more information at the NAI 1stValley Las Cruces office at (575) 521-1535.