Most people have heard Aaron Copeland’s “Fanfare for the Common Man.” Written for a robust brass section of four French horns, three trumpets, three trombones, a tuba, plus a timpani, bass drum, and tam-tam, Copeland’s fanfare is the best-known of 18 fanfares commissioned in 1942 by Eugene Goossens, conductor of the Cincinnati Symphony. Goossens’ goal in commissioning these fanfares was to inspire support for the war effort.
Most fanfares had military themes, such as Fanfare for Airmen and Fanfare for the American Soldier. However, Copeland struggled to find a title for his fanfare. He considered Fanfare for the Spirit of Democracy and Fanfare for the Four Freedoms (speech, religion, and freedom from want and fear). He chose Fanfare for the Common Man because he felt it was the common man “who was doing all the dirty work in the war and the army.”
Goossens selected March 12, 1943, for the first performance of Copeland’s Fanfare. The date was no accident. It was chosen to coincide with the March 15 federal income tax payment deadline.
Premiering Fanfare for the Common Man near to Tax Day recognized the people’s financial sacrifices to pay for the war effort. Goossens chose tax day because “the common man will be paying his income tax two days later (if he has anything left to pay it with”).
In 1943, that was an apt statement. The United States had been at war for more than a year. Taxes had to be increased to pay for those costs. Payroll withholding was new. So many taxpayers had past-due taxes from previous years, and March 15 marked the day when their past-due tax liability might increase further.
We currently are more than a year into a different type of war–a war against COVID-19. There have been sacrifices, both of human life and financially. The government has committed significant amounts to COVID-19 relief to help people and the economy survive the pandemic.
Inevitably, taxpayers will need to pay for COVID-19 relief. The question is what tax law changes will be made to generate additional tax revenue. And since tax policy also shapes taxpayer behavior, the country likely will see a changing business and investment environment in response to increased taxes.
Less than a month ago, in Re-Evaluating Real Estate Dispositions Under the Biden Tax Plan, I outlined expected tax proposals and how they might affect real estate transactions. Since then, President Biden has announced the American Families Plan.
Although the American Families Plan proposes many benefits expected to help middle-class families, it also includes changes in the tax law, presumably to pay for those benefits. This article part of a series discussing how the American Families Plan might affect real estate investments and discusses long-term capital gains and carried interest.
Long-Term Capital Gains Rate–Why Treat Some Gains Differently?
There are two main ways that an investor might owe taxes when they sell investment real estate:
Appreciation or increase in value (i.e., the property is sold for more than what is invested in it), called “capital gains” and
“Recapture” of depreciation expenses that the investor took while he/she owned the investment real estate. Although land cannot be depreciated, buildings can be, so there can be a significant tax liability upon sale of the investment.
Tax law distinguishes capital gains based upon how long the investor owned the property. If the investor owned the property for more than one year, it is a “long-term capital gain.” Gains on property held for less time are called “short-term capital gains.”
Short-term capital gains are taxed at the same rates as regular income. But long-term capital gains currently are taxed at lower tax rates. By taxing long-term capital gains at a lower rate, people have an incentive to save money and make investments.
Also, lower long-term capital gains rates can be viewed as an attempt to adjust taxes for inflation. If someone buys a property for $100,000 and sells it for $150,000 six months after buying it, the cost of living has changed little between the purchase and sale. So, the $50,000 gain reflects an increase in real value (nominal value adjusted for inflation) to the investor.
But if an investor invested $100,000 in a property in March 2001, the equivalent value in March 2021 adjusted for the Consumer Price Index would be $150,327.47. Selling the property at $150,000 would show a nominal gain of 50 percent while the real value of the investment is essentially unchanged. Some would say that the lower long-term capital gain rate would help compensate for such phantom changes in asset value.
Sponsor Compensation Through a Carried Interest
Sponsors also benefit from long-term capital gains treatment. One way real estate sponsors make money from putting together investments is called a “carried interest.” To incentivize sponsors to manage the investment well, they have the right to a percentage of the gain when the real estate is sold. The sponsor doesn’t receive its payment unless the investment is successful. That’s because the sponsor usually only gets paid after the investors get all of their money back plus a guaranteed “preferred” return similar to interest.
Because a real estate sponsor may never receive a dime from its carried interest, it has no value at the beginning of the investment. A carried interest might be viewed as a bet on the success of the investment. Once a gambling bet is made, there is no value until the bet pays out.
Because the carried interest is given a tax basis of zero when the real estate is purchased, any amount the sponsor receives is a capital gain. If the real estate is held for three years (versus one year for investors), any payment the sponsor receives from its carried interest is treated as a long-term capital gain.
The American Families Plan Would Eliminate Long-Term Capital Gains Tax Rates
The American Families Plan seeks to eliminate long-term capital gains tax rates. Gains from asset sales would be taxed at the same rate whether the seller owned the property for six months or sixty years.
Eliminating the long-term capital gains rate is likely to slow down the real estate market because it changes the economics of a property sale. Why sell a performing asset if you know you will owe a huge tax bill? The result may be less inventory on the investment real estate market. It could become a “seller’s market” with increasing prices.
Real estate investors frequently evaluate the success of their investment based upon the internal rate of return (IRR). IRR is a discount rate (interest rate) at which the net present value of cash flows from the investment is zero.
Since IRR is based upon the time value of money, the timing of the cash flow from disposition significantly affects the IRR. So, when a sale is deferred, IRR goes down. If investors hold assets for longer periods to delay realizing a taxable gain, they will need to increase current cash flow to obtain the IRR investors expect.
There are two ways to increase current cash flow–increase income or reduce expenses. Since rental rates are affected by supply and demand, there’s a limit to how much an owner can increase rental rates. Owners may find it easier to reduce expenses by cutting amenities and deferring maintenance.
Also, capital expenditures frequently are made upon acquisition (when the investor has new financing) or to prepare for disposition (in hopes of a higher sale price). Therefore, extending asset hold periods is likely to reduce capital improvements on properties, which will affect property condition.
Long-Term Capital Gains Rates and Carried Interest
Although the American Families Plan proposes “permanently eliminating carried interest,” this isn’t technically accurate. Sponsors still probably will be able to receive carried interests. However, by eliminating long-term capital gains rates, gains on carried interests would be treated the same as all other sponsor income.
Taxing payments on a sponsor’s carried interest as regular income is likely to change how sponsors real estate investments. Without long-term capital gains treatment and less incentive for investors to sell and trigger payment on the carried interest, sponsor fee structures could change.
With sponsors disincentivized from waiting until the property is sold to receive their compensation, they might, instead of a carried interest, increase annual asset management fees or require higher upfront fees. And without a carried interest, sponsors may be less focused on the long-term increase in real estate value. Instead, the focus may be on income from the investment.
A real estate investment held primarily for current income rather than long-term gain may be managed differently. Since maintenance and capital expenditures can reduce the cash available to distribute as investor income, there is less incentive for owners not to make repairs or improvements.
Changing Real Estate Investment Strategies
Although taxes raise money for the government, tax policies also incentivize (and disincentivize) taxpayer behavior. Research differs on whether the significant increase in the American Families Plan would increase total tax revenue after considering the reduction in property dispositions. However, Tax Policy Center’s research comparing historical capital gains rates to transaction volume supports the idea that investors change behavior based upon long-term capital gains tax rates.
Therefore, if long-term capital gains rates are eliminated, it’s likely that sponsors and investors will adjust investment strategies to compensate for the increased taxes. Some of these adjustments might include:
Increased use of installment sales and seller financing to spread sale proceeds into several tax years
Reduced sponsor investment in the real asset’s long-term success through reduction or elimination of carried interests in favor of annual fee income
Longer hold periods
Strategic maintenance deferral
Fewer capital projects
Reduced real estate transaction volume
Currently, real estate is an attractive investment because it can provide legal tax sheltering of income through depreciation and a reduced tax rate on long-term capital gains. United States real estate investment is also how investors can invest locally–since real estate can’t move, it and jobs maintaining it are local and can’t be outsourced abroad.
If the capital gains tax rate is eliminated, investors have little incentive to invest in long-term investments generally and real estate specifically. It’s possible that would-be investors instead will spend their money and stimulate economic growth. It’s also possible they will choose other investments, which may include an international component.
Most sponsor real estate proformas don’t include an investor income tax analysis. That makes sense since each investor’s tax situation is unique. Until investors know how their real estate investment income will be taxed, they should create pro formas showing multiple scenarios and evaluate the potential tax liability for each.
This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.