Debt is nothing more than future income pulled forward and we now find ourselves with plenty of future income pulled forward at the federal, state and local levels. The federal debt currently stands at more than $27 trillion and some economists see this ballooning to nearly $50 trillion by the end of 2030. Democrats and Republicans have different views on how we should tackle this problem. If the Republicans win in November, we most likely won’t see much change in the tax laws and it will be business as usual. However, a Democrat sweep of the upcoming elections means there are likely many changes ahead which could have far reaching ramifications.
If you make more than $400,000 a year, your taxes are likely to go up. The highest personal income tax will likely rise from 37 to 39.6 percent, corporate taxes will increase, itemized deductions will be capped, and the 20 percent deduction for qualified business income will be phased out.
Probably the three most important proposals to real estate investors include:
- Eliminating the step-up in basis for inherited assets, meaning more taxes on wealth passed to heirs and lowering the federal estate tax exemption from $11.58 million to around $5 million.
- Ending favorable tax rates on capital gains for anyone making more than $1 million a year. Democratic Presidential Nominee Joe Biden proposed increasing the tax from 23.8 to 39.6 percent for top earners. This would be the largest real tax increase in history.
- Eliminating 1031 “like-kind” exchanges if your annual income is more than $400,000.
From Proposal to Law?
Could any of these proposals become law? First, let’s look at polling data to see where the candidates stand and the likelihood of Biden getting elected. I like to follow the Real Clear Politics national average poll because it takes a number of national polls into consideration and has a large sample size. The RCP national average has Biden at 51.3 and President Trump at 42.4.
The latest Wall Street Journal/NBC poll has Biden ahead by eleven points. Notably, Hillary Clinton was ahead of Trump by five points in this poll four years ago.
The Investor’s Business Daily poll known as the IBD/TIPP claims to be “America’s most accurate national poll” and was one of few that got it right in 2016. Biden leads Trump 49 to 44.
That’s a look at polling data from three different sources, all of which point to a similar conclusion. But remember Biden would need a Democrat majority in Congress to make any major changes to your taxes.
The Odds of a Democrat Sweep
Let’s get some odds on which way Congress might go in the elections. And we’ll also find the odds of Biden winning.
For these probabilities, I’m going to pull data from a prediction market. These are exchange-traded markets created for the purpose of trading the outcome of events like elections and sporting events, among others. The prices of the contracts indicate the probability of an event happening or not. For example, a contract trading for $0.25 indicates a 25 percent probability of player X winning the match.
Please understand that online gambling is against the law in the U.S. But notable exceptions include the Iowa Electronic Markets, run by the University of Iowa under a no-action letter from the Commodity Futures Trading Commission. Another is PredictIt, operated by Victoria University of Wellington under a similar no-action letter.
At the time of this writing, PredictIt’s current markets for the 2020 elections are below:
101.7M shares traded
Biden @ $0.63
Trump @ $0.41
1.2M shares traded
D win Senate @ $0.60
R win Senate @ $0.42
1.6M shares traded
D control House @ $0.85
R control House @ $0.17
Let’s do the math on the odds of a blue wave sweeping through D.C.
0.63 x 0.60 x 0.85 = 0.32
There’s a 32 percent chance the Democrats sweep the elections, according to the PredictIt markets.
Proposed Changes to Qualified Opportunity Zones
The 2017 Tax Cuts and Jobs Act created Opportunity Zones to incentivize development in economically distressed areas and the resulting Qualified Opportunity Zone (QOZ) program. Rules governing opportunity zones could be another change that’s coming. Republicans will expand the program while Democrats want to revise some of the rules.
Here are the four rule changes to the QOZ program that are likely to happen if there is a Democratic sweep:
- Incentivize funds to partner with community organizations.
- Appoint the Treasury Department to review regulations and ensure tax incentives have economic, social, and environmental benefits to a community.
- Require developers to provide detailed reporting and public disclosure about their investments.
- Revisit the QOZ map and update it to reflect the 2020 census.
The QOZ maps were drawn using the 2010 census data and many cities have changed since then. Much of the QOZ capital today is going to neighborhoods that are not economically distressed because they have already transitioned, and the tax benefit is simply viewed as a giveaway by the Democrats. However, as the law is written now, investors only get a tax benefit if the project does well, which forces sponsors to develop in more desirable areas. The program is certainly creating jobs, but the social benefits of the program are not being met. All these changes seem reasonable, but it will certainly make it harder to do business for many funds, which means less opportunities for investors.
What Happens If There’s a Sweep?
A blue wave on election night might motivate you to think about how to get assets out of your estate before any laws change. The Democrats are not going to retroactively change any laws, so that would mean there wouldn’t be tax on inherited wealth up to $11.58 million for the remainder of 2020. Two gifting strategies you could consider to take advantage of the exemption include:
- Transferring wealth to children by establishing a trust.
- Selling assets to trusts or family members.
Other strategies like selling investments with capital gains or even converting traditional individual retirement accounts to a Roth might make sense if you think your taxes are going up.
Generally, it’s too risky to make knee jerk reactions but we might look back in a few years and realize that we were in one of the most favorable tax environments we will ever see in our lifetimes, and the window may be closing quickly. The elections could go several different ways and the proposals that are on the table could take many twists and turns ever before becoming law.
When it comes to real estate, moving assets that have appreciated into a QOZ fund might be worth your consideration if the tax rate on capital gains increases. And this might be even more beneficial if 1031 exchanges are eliminated. But keep in mind that 1031 exchanges have been part of the tax code since 1921. The law still stands because most lawmakers understand its positive impact on the economy.
Regardless of which candidate or party wins, at Origin we believe the long-term outlook for private real estate remains positive. Your ability to generate high absolute returns in this asset class is likely to continue longer after the 2020 elections are over.
From our perspective at Origin Investments, we own high quality properties in high growth cities, and operate our funds in the most tax efficient manner possible. We’re bullish on high growth cities in tax friendly states and are confident these markets are the best places to invest no matter who wins the elections.