On September 15, 2021, the House Ways and Means Committee approved tax increase provisions Congress will review as a part of the Build Back Better reconciliation legislation. These changes, if enacted, would require real estate and construction businesses to reset some of their key traditional tax planning strategies.
Below is a look at three main areas of taxation that may change, and that you should begin preparing for now.
1. Tax Rate Increases
Top Marginal Individual Tax Rates
Effective after December 31, 2021, if enacted individual top rates would increase from 37% to 39.6% for:
- Married individuals filing jointly with taxable income over $450,000;
- Heads of households with taxable income over $425,000;
- Unmarried individuals with taxable income over $400,000;
- Married individuals filing separate returns with taxable income over $225,000; and
- Estates and trusts with taxable income over $12,500.
Capital Gain and Qualified Dividend Rates
These rates would increase from 20% to 25% for tax years ending after September 13, 2021. There would be a transition rule that would retain the 20% tax rate for capital gains and qualified dividend income recognized on or before September 13, 2021.
High Income Surcharge
A new 3% surcharge on a taxpayer’s modified adjusted gross income in excess of $5 million ($2.5 million for a married individual filing separately) or $100,000 for a trust or estate. The effective date would be for tax years beginning after December 31, 2021.
Net investment income tax (NIIT)
The NIIT rate of 3.8% would be expanded to apply to specified income derived in the ordinary course of a trade or business for taxpayers with greater than $400,000 in taxable income (single filer) or $500,000 (joint filer), as well as for trusts and estates for income in their top tax rate. The effective date would be for tax years beginning after December 31, 2021.
This change would effectively subject all earnings from pass-through businesses to either the 3.8% self-employment Medicare tax or the 3.8% NIIT.
Qualified Business Income Deduction (QBID)
Section 199A, otherwise known as QBID, provides a deduction of up to 20% on qualified business income to the owners of pass-through business entities, which essentially decreases the top marginal individual tax rate down from 37% to 29.6%. The proposed changes modify the QBID by setting a maximum deduction at $500,000 in the case of a joint return, $400,000 for an individual return, $250,000 for a married individual filing a separate return, and $10,000 for a trust or estate. This change would result in business income that is not eligible for QBID taxed at 39.6%. The effective date slated is for tax years beginning after December 31, 2021.
Section 1061, enacted under the Tax Cuts and Jobs Act (TCJA) of 2017, increased the holding period to qualify for long-term capital gain related to certain partnership interests to three years. The TCJA recharacterized capital gain from interests not meeting the holding period requirement as ordinary income. Section 1231, which is common in real estate, was not subject to Section 1061.
The proposal would increase the three-year holding period to a five-year holding period for an applicable partnership interest, and extend Section 1061 to include all gains eligible for long-term capital gains rates (including Section 1231 gain). Any income from a partnership interest that is from a real property trade or business, within the meaning of Section 469(c)(7)(C), would retain a three-year holding requirement. The effective date would begin for tax years beginning after December 31, 2021.
2. Limitations on Deductions
Excess Business Losses
The TCJA limited the deduction of business losses incurred by noncorporate taxpayers in excess of $250,000 ($500,000 for joint filers). Losses limited under this rule were considered a net operating loss (NOL). The CARES Act repealed the excess business loss rules for tax years beginning before 2021.
The current proposal makes permanent limitations on excess business losses of noncorporate taxpayers and no longer allows losses limited to be considered NOLs. Instead, taxpayers whose losses are disallowed may carry those losses forward to tax years where they would be treated as excess business losses and considered as part of the $250,000 or $500,000 limitation for that year. This change would go into effect for tax years beginning after December 31, 2020.
Interest Expense Limitations
The Build Back Better bill would modify business interest expense limitations under Section 163(j) for partnerships and S Corporations to apply at the shareholder/partner level. The bill would also provide a five-year carryover of disallowed interest expense. The effective date would be for tax years beginning after December 31, 2021.
Exclusion for Gain of Small Business Stock Deduction
Under current law, taxpayers other than corporations may exclude between 50% and 100% of the gain from the sale of qualified small business stock acquired at original issue held for five years. The proposal would eliminate the 75% and 100% exclusion rates for taxpayers with adjusted gross income equal or exceeding $400,000, or for any trust or estate. The 50% exclusion would remain available to all taxpayers. This change would be effective for sales and exchanges on or after September 13, 2021.
Worthless Partnership Interests
Current case law and IRS guidance allows a partnership interest that was deemed worthless to result in an ordinary loss. The proposal in the Build Back Better bill would treat worthless partnership interest as a loss from the sale or exchange of a capital asset, resulting in a capital loss.
3. Estate and Gift Tax Provisions
The lifetime exemption
This exemption, the “unified credit,” is proposed to be reduced from $11.7 million per person to $6 million per person. The provision would apply to decedents dying and gifts made after December 31, 2021.
New Section 2901 would include all grantor trusts in a decedent’s taxable estate when the decedent is the deemed owner of the trusts for income tax purposes. Prior to this provision, taxpayers could use defective grantor trusts to exclude assets from their estate. This provision would be effective for trusts created on or after the date of enactment of the bill, and to any portion of a trust created before the date of enactment that is attributable to a contribution made on or after date of enactment.
Sales to Defective Grantor Trusts
Under Section 1062 of the bill, sales between grantor trusts and their deemed owner would be treated as a sale to a third party, which would trigger gain. This provision would be effective for trusts created on or after the date of enactment of the bill, and to any portion of a trust created before the date of enactment that is attributable to a contribution made on or after date of enactment.
While we wait to see if these provisions make it into the final reconciliation legislation, business owners should begin discussing these proposals and their various effective dates now with tax advisers to determine the potential impact. There is still time to adjust tax strategies to take advantage of the lower rates and expanded estate exemption currently in play.
Contact Dave Sobochan at firstname.lastname@example.org or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.