The Latest White House Tax Code Idea

The Real Estate Espresso Podcast

The Latest White House Tax Code Idea

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The Latest White House Tax Code Idea

Welcome to the Real Estate Espresso Podcast, your morning shot of what’s new in the world of real estate investing. I’m your host, Victor Menasce. On today’s show, we’re looking at what might become another tectonic force in the world of real estate investing.

The White House provides a steady stream of topics worthy of discussing on any real estate podcast. This week was no exception. On Tuesday, the President floated the idea that houses may become exempt from capital gains tax. The thinking is that this could stimulate the real estate market. Of course, a change like this to the tax code would require congressional and senate involvement. The final definition of what type of property will qualify to achieve the tax exempt status has not yet been articulated. So today, we’re venturing into the dangerous realm of speculation for what might be.

In today’s tax code, there are several ways to defer or, in some cases, outright avoid capital gains tax. Let me be clear, we’re talking about tax avoidance, not tax evasion, which is something completely different. By taking an investment gain and investing it in a qualified opportunity zone, you can shelter your investment from capital gains tax. This is true for the sale of an apartment complex or a single-family home. Both can be sheltered using a qualified opportunities zone investment.

You could also shelter yourself from capital gains tax obligation by doing a like-kind exchange under section 1031 of the tax code. This is the so-called 1031 exchange. Both of these come with a considerable, but not insurmountable, amount of paperwork. If you absolutely want to shelter investment from capital gains, you do have mechanisms available today. However, neither the qualified opportunity zone nor the 1031 are easy to use.

In the case of the 1031, you’ve got 45 days to identify the replacement property and then another 135 days to close after that. Forty-five days is not a lot of time and it goes by quickly. Rather than buying a poor investment property just to meet that 45-day deadline, some would rather just pay tax.

The notion of making a home tax exempt is not entirely new. In Canada, for instance, real estate is subject to capital gains tax treatment, but there’s an exemption for your principal residence. If let’s say, you own three single-family homes, your principal residence would be exempt from capital gains tax. However, maybe your cottage and rental property would be subject to capital gains tax when you sell them. Moreover, if you change the use of your principal residence from being the place where you live to a rental, you would lose that principal residence exemption.

In the U.S., there’s considerable demand for detached housing. The problem, however, is affordability for many households and states like California are experiencing falling homeownership. If people can afford a home, they generally buy one. Some are tenants by choice, but most are not.

The U.S. also has a primary residence exclusion where you can exclude up to $250,000 in capital gains if you’re a single filer and half a million dollars if you’re married and filing your tax return jointly. To qualify, you must have owned your home for at least two out of the five years before the sale, and you’ve used the home as your primary residence for at least two of those five years before the sale. These two years do not need to be consecutive, and you can only claim this exclusion once every two years.

The only way to drive investment in more houses is by making rental homes tax exempt. If someone wants to buy a house to live in, they’re not thinking, “Oh, I better think twice about buying a house because if it goes up in value, I may have to pay capital gains tax.” They’re thinking primarily about where they want to live, where will the kids go to school, and how far it is to drive to work and the grocery store. So, a capital gains tax exemption would do nothing to stimulate the market for owner-occupied homes.

Many smaller investors don’t invest in real estate because either they don’t understand it, or they don’t want the headache of managing a physical asset like a property. So the real question is, where will the administration create the incentive? Will it be single-family homes? Maybe if they have an accessory dwelling unit, will that still qualify? After all, what’s the difference between a duplex and a single family home with an accessory dwelling unit? Both provide housing for two families. Will the definition of tax exempt properties follow the classic residential one to four definition, and consider anything commercial of five units and above as subject to capital gains tax? At this point, we don’t know as it hasn’t been implemented. However, if it does get implemented, we can reasonably expect that smaller investors will overwhelmingly choose properties that qualify for the tax exemption.

This could lead to a situation where capital that would have been invested in apartments will no longer consider apartment investing as an option. Even larger investors may choose to maximize their tax exempt investing up to the point wherever those limits get placed on the tax exemption. While the exemption may stimulate single family home investing, we can only expect that apartment investments might be an unintended casualty of such an initiative.

As you think about this, I wish you a fantastic rest of your day. Go make some great things happen. I’ll talk to you tomorrow.

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