It is clear that in the US it has, historically, been a basic tenet that it is a favorable position for the society to encourage, or at least not to discourage, the free ability and opportunity for property owners to be able to transfer their real estate (and other property).
However, although this basic principle of supporting the free alienation of property has existed in the US even back to colonial times, there is an argument that recent legislation on the Federal level is creating tax laws that discourage the transfer of real estate. If this is a correct assertion as to the current state of the law, this has important implications in the US.
This hypothesis of tax laws discouraging the disposition of real estate is examined in this short Tip, along with examining a few of the negative implications that have been generated because of the failure to transfer real estate.
The tax positions that may be discouraging the transfer of real estate are present, as noted below, on the Federal level. Some of the same tax laws may also be present in many states.
The following brief comments are merely set out as examples of some of the tax laws and positions that may be discouraging the movement or transfer of realty.
Examples of Tax Changes or Proposed Changes that Deter Transfers of Real Estate
One change that is being proposed by the Biden Administration (BA) is an increase in the tax rates on corporations. The current rate is 21%; the proposal is to move the rates to 28%. Thus, if a corporation is taxed at a higher rate, might the entity choose not to dispose of property, thus avoiding this increased rate? Would the same be true, if the tax rate is increased for individuals? There is such a proposal by the BA. If such increase occurs, would a taxpayer consider not selling a property, thus avoiding the tax all together? (The current increase being considered by the BA is to move from 37% on the high side to 39.6%; this is not a large increase. However, might it be enough to have taxpayers focus on simply avoiding the tax by not selling?)
How much increase might be enough to cause a potential seller to hold property?
Also being considered is the potential of increasing the long term capital gains income tax from a maximum of 20% or to consider taxing many transactions at this 20%, even if, today, they may be taxed at a lesser number, such as 15%. The BA has raised the possibility of taxing some larger capital gain transactions at a rate of 39.6%. Would such rate encourage a potential seller to postpone the transfer or sale of the property in question?
Tax Deferred Exchanges:
Another potential change in the Federal income tax law deals with an area known as “tax deferred exchanges.” This area under Internal Revenue Code Section 1031 allows a qualified taxpayer to exchange like kind, qualified real estate for other like kind, qualified real estate used in the trade or business and defer any income tax on such transfers. (For more detail on this issue, see Levine, Mark Lee, Handbook on Exchanging Real Estate, PP & E (2020).)
This proposal to either eliminate or reduce the application of Section 1031 certainly may discourage a taxpayer from transferring his or her realty. (Congress already saw fit to reduce the application of this Section under the Tax Cuts and Jobs Act of 2017, when it eliminated the ability to undertake a Code Section 1031 exchange of personal property.)
Qualified Opportunity Zone Fund:
Another example of a tax law that might be discouraging taxpayers from transferring property for many years is the area known as a Qualified Opportunity Zone Fund (QOZF).
Under a more recent law, prior to the BA, Congress passed a law to arguably encourage investment in certain areas, known as a Qualified Opportunity Zone (QOZ). Without examining the details of such law, the essence of the law provides that if taxpayers will invest in these special areas, a QOZ, tax benefits can be gained. These benefits include possibly allowing for deferral of tax when moving out of one investment and into a QOZF; and potentially allowing for the elimination of taxable income that would be generated, if the taxpayer has a gain while being invested in the QOZF. However, and very relevant to the focus of this Tip , the taxpayer cannot gain the tax benefits noted of excluding gain, unless the taxpayer stays in the QOZF for a given number of years. (How long the taxpayer must hold the investment in the Zone controls in part how much gain will be excluded from taxation. If, for example, the taxpayer holds the investment in the Zone for at least 10 years, all of the gain generated while in the Fund is excluded from Federal taxation.)
Thus, even with the few examples given above, be it an increase in tax rates, an elimination of Section 1031 exchanges, or the investment in a QOZF, it is apparent that such tax laws may influence the actions of taxpayers in deciding to hold or to dispose of their real estate.
It might, therefore, behoove Congress and the BA to consider the implications of Federal tax changes and how they impact the behavior of taxpayers who may be deterred from transferring real estate because of such changes.
***For a full article discussing in more detail this issue of Federal tax changes and their impact on real estate, see Levine, Mark Lee and Segev, Libbi Levine, “WHAT ARE THE IMPLICATIONS TO SOCIETY IF THERE ARE TAX CHANGES (AND PROPOSALS) THAT INHIBIT THE ACTIVE AND FREE ALIENATION OF REAL ESTATE?” RELJ, scheduled for publication in April 2021***
Dr. Mark Lee Levine,
Professor, University of Denver