Happy November! After a stressful ballot-counting process, Joe Biden is now slated to become the 46th US President. One major question you might have as an investor is: how will a Biden presidency affect my taxes? In this newsletter, we break down and provide numbers for some of the more important taxes.
The president-elect has a lengthy list of new taxes he would like to implement. The magic number is $400,000: these changes are only intended to affect those with annual income (including salary + investment income) above that threshold. If this applies to you, we highly recommend meeting with a tax advisor as well as re-examining your estate planning where possible to offset the potential tax hike.
Here are the most relevant changes:
Biden promises to raise taxes for Americans earning more than $400,000. In particular, he plans to reinstate the top marginal tax rate of 39.6%, which had been lowered to 37% under the Trump Administration.
Biden has implied that individuals earning $400,000+ will all fall within this uppermost tax bracket. This is lower than the current threshold of $500,130 for the tax bracket.
Capital Gains Tax
Biden plans to hike capital gains taxes on individuals earning more than $1 million. Whereas the highest capital gains tax currently sits at 20%, his proposal would increase this to 39.6%. This may pose a particular risk for stock investors as well as those in high-growth real estate markets. But perhaps the biggest change for real estate investors is that Biden plans on eliminating our favorite tool, the Section 1031 exchange, for those earning more than $400,000 annually. The 1031 exchange, which allows investors to defer capital gains taxes if they invest their gains into a second property, has allowed many investors to make strategic acquisitions to expand their portfolio.
Currently employers and employees split a 15.3% payroll tax, which covers both Social Security (12.4%) and Medicare (2.9%). Employees are responsible for paying half of the contribution, or 7.65%. While the payroll tax is currently applied to all wages earned up to $137,700, Biden plans to also apply the tax for amounts above $400,000. Some observers have taken to calling this a “donut tax”.
Biden claims his plan would not affect taxes for individuals earning less than $400,000. Let’s walk through some numbers to see if this holds true.
Note: in the following examples, we assume the capital gains tax is on the characters’ primary residence.
Example 1: Sally
Sally is a resident of Austin, Texas. Sally has just sold her house for $1,000,000 that she bought 1 year ago, for a profit of $500,000. Sally works for a major investment bank where she makes $300,000 annually before-tax.
As you can see, Sally’s capital gains tax, income tax, and payroll tax do not change if Biden’s tax policy is implemented.
Example 2a: Regular Dave
Dave is Sally’s neighbor, who also sold his house for the same amount and recorded the same capital gain. Unlike Sally, however, Dave’s income is $800,000 annually before-tax.
Dave’s after-tax income falls by 9% under Biden’s proposed tax policy. As shown above, Dave does not make more than $1 million, so he continues to pay capital gains at the existing rate of 20%. However, Dave’s income tax and payroll taxes are significantly higher in this scenario.
Example 2b: Investor Dave
Now let’s assume that Dave is a real estate investor. As it exists currently, Dave can use the 1031-tax exchange loophole to reinvest his $500,000 of capital gains into an investment property, thereby eliminating his capital gains tax this year.
Under the Biden proposal, Dave must pay a capital gains tax, regardless of whether he purchases that second property. As mentioned above, he would be paying at a rate of 20%. This rate would not increase for Dave under a Biden administration.
In this hypothetical scenario, Dave’s income has plummeted nearly 18%. This is because, as an investor, Dave had the option to defer his capital gains tax. For Dave, the capital gains tax under a Biden administration would be an extra cost which he did not have to pay before.
Example 3a: Regular Wendy
Wendy is the heiress of a multi-million dollar hot pocket empire, which she will inherit after her father’s death. Currently, Wendy is employed as the CFO of the Hot Pocket Corporation, where she makes $2 million annually. Wendy lives in the same neighborhood as Sally and Dave because of its proximity to corporate headquarters.
Wendy is the most “unfortunate” of the bunch under a Biden presidency. Due to her high income, she pays a significantly higher capital gains tax of 39.6%. Furthermore, $1.6 million of her income belongs to the highest tax bracket, which results in her nearly paying an extra $44,000 after the new tax policy. But by far the most drastic change is in Wendy’s payroll tax, which increases by more than $120,000. Wendy’s after-tax income declines by 17%.
Example 3b: Investor Wendy
Like with Dave, we’ll now look at the numbers for Investor Wendy. Unfortunately for Wendy, not only will she be paying a capital gains tax that she did not have to pay previously, but since she falls in the $1 million+ bracket, she will also have to pay at almost double the rate for her gains (39.6% compared with the current 20%).
As shown, Wendy’s after-tax income falls by 21%.
In the examples above Sally, Dave, and Wendy were affected by the new taxes to varying degrees. Sally’s taxes did not change, while for Dave some increased and others stayed the same. On the other hand, Wendy fell squarely into the high wage-earner category, so she suffered the biggest tax burden increase of the bunch. This analysis is in line with what other reporters have found, which is that the top 1% of wage earners will see their after-tax income decline by 16% on average. The proposed changes would have an outsized influence on the highest income percentile, and in particular, investors who use a Section-1031 exchange.
Those below the top 1% (whose cutoff, as of 2020, was $540,000) will be relatively less affected. Below $400,000 in income, we expect to see no direct tax increases to individuals, but some indirect impacts may filter down from Biden’s other tax policies on corporations - such as his plan to raise the corporate tax rate from 21% to 28%.
How to go about addressing the proposed tax increase? One way would be to sell off any appreciated properties and take advantage of the Section 1031 tax exchange while it’s still around. Perhaps you’ve been sitting on top of a (literal) gold mine, just waiting for the right moment to sell - do your own cost-benefit analysis to see if it’s worth it.
Another way to get around future capital gains taxes, that won’t require you to act this year, is by investing through retirement accounts. IRA and 401(k) plans have been much slept on in the world of real estate investment, with only 2% of them holding alternative investments. The tax-deferred nature of these plans could be your safe harbor in the event that the 1031-exchange goes away.
While this scenario may seem bleak (depending on how much you make!) it’s not guaranteed that all, or even any, of these taxes would be implemented under a Biden presidency. Taxes require approval in both chambers of Congress; although Democrats will likely continue to enjoy a majority in the House, depending on the results of Georgia’s Senate runoff this coming January, they may fall short of the majority needed to approve the increases. You may want to avoid making a rushed decision before knowing whether or not the President will get his tax increases through.
Markets, for one, seem optimistic about the news. A Biden presidency along with a split Congress would likely prevent tax increases from happening, although this will come with a reduced fiscal stimulus. But whatever the prediction, it’s important to be familiar with Biden’s proposal and know how it affects you.