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Thanks to advances in technology and changes in regulations over the last several years, individual investors have more opportunities than ever to invest in real estate assets that were once the domain of large institutions. Individual investors can now, through avenues such as crowdfunding, construct diversified portfolios that include both equity and debt investments tied to either a single property or a collection of them.
Savvy investors often choose to diversify their holdings to include both equity and debt investments, which each have their own unique benefits.
With an equity investment, an investor becomes a shareholder in a property or a portfolio of properties and is entitled to a proportionate share of the returns from the investment. While equity investments can carry more risk than debt, an investor has the potential to reap outsized returns. With a debt investment, an investor participates as a project’s lender and is entitled to interest rate payments until maturity or a capital event. This allows them to benefit from the steady cash flow that debt investments can offer.
One important element knowledgeable investors typically factor into their investment decisions is the different tax treatment on debt versus equity investments. When an equity investor receives a profit from a real estate deal after holding the asset for at least a year, that return is typically taxed at the long-term capital gains tax rate (which is lower than ordinary income tax rates), while the income payment typically received from debt investments are taxed at the higher ordinary income tax rate.
This distinction is especially important as the Biden administration is considering increasing the long-term capital gains tax rate, which can result in investors paying more upon the sale of their real estate investments. As a result, the tax treatment advantage that equity investments have typically held over debt investments due to capital gains treatment on equity profits may soon disappear or be diminished because of tax reform plans, leading to a more level playing field between the two investment types.
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Understanding The Capital Gains Tax
Capital gains tax is a tax on the growth in the value of an investment and is levied when the investment is sold. Early in U.S. income tax history, capital gains were taxed as ordinary income, but a separate capital gains tax rate of 12.5% was introduced in 1922. This was done in order to encourage long-term investments that could help build wealth while also spurring economic growth. The rate has fluctuated numerous times over the last century.
Currently, the capital gains tax rate is determined by how long an investment has been held and an investor’s tax bracket. Profits from investments held for less than a year are called “short-term capital gains” and are generally taxed as ordinary income, which has a top rate of 37%. Gains from investments held for more than a year — or long-term capital gains — are taxed at 15% or 20%, based on income levels. The Medicare surcharge on investment gains, introduced in 2013 and which applies absent a recognized exemption, can make the long-term capital gains tax rate as high as 23.8%. Individuals and married couples making under $40,000 and $80,000 a year, respectively, are not charged long-term capital gains taxes.
The administration has proposed nearly doubling the long-term capital gains tax rate to 39.6% for households with $1 million or more in annual earnings. It has also suggested eliminating any Medicare surcharge exemptions, which would increase the tax liability for some real estate investors to 43.4%. Accordingly, the potential surge in the capital gains tax rate could decrease a tax saving that had historically benefitted real estate investors who participate in equity deals.
What’s more, the administration’s proposal aims to eliminate the “step-up in basis” upon death and curb Section 1031 like-kind exchange benefits. Both could saddle many real estate investors with significant new tax burdens.
A Shift In Investment Strategies
As of today, the capital gains tax proposals exist only on paper, but if they become law, the plans could impact investors’ real estate strategies. For example, due to the additional tax burden on gains from real estate equity investments, instead of selling their properties, real estate investors may decide to pull cash out by refinancing the debt attached to them. And the drag on real estate transactions could lead to less liquidity in the market and stifle appreciation.
Moreover, these tax reforms can make investments in real estate debt more appealing by lessening the 19.6 percentage point capital gains tax gap currently seen between some equity and debt investments. If equity and debt investments are taxed at the same ordinary income rates, or even if the capital gains tax rate is increased to a level that more closely resembles the ordinary tax rate, investors who take the potential tax burden into account when making investment decisions will likely change the way they look at debt.
Typically, debt instruments, like mortgage and mezzanine loans, have not been available to individual investors to the same extent as equity investments. However, some real estate crowdfunding platforms are opening these debt investments to everyday investors. If the Biden administration’s plan is enacted, this may be a boon for the debt markets as more capital will flow to the space that suddenly finds itself on a more even playing field with equity investments.
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