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The Tax Man Cometh?

Real estate investors face a growing risk that taxes on capital gains could increase sharply as Congress looks to cut the ballooning $1.6 trillion U.S. budget deficit. Three factors make this risk especially great for real estate investors. First, is economic: The mounting deficit recently caused Fitch to downgrade U.S. debt from AAA to AA+, which will tend to raise the nation’s borrowing costs and add pressure for a fiscal correction. Second is the nature of real estate assets, which have especially high measures of unrealized capital gains. Third is political: The deficit — which increased dramatically in the first 11 months of the 2023 fiscal year — has become a top public concern, and capital gains are concentrated among high-income households that comprise only a small minority of voters.

Addressing the annual budget deficit, as well as the skyrocketing $33 trillion gross national debt, is painfully difficult given that Congress is fiercely divided over how to close the gap between what the U.S. spends and what it collects. Yet the deficit crisis can only be mitigated by a combination of reduced spending and increased taxes. Lowering federal spending involves many societal tradeoffs and is beyond the scope of this article. On the tax side, the choices are more explicitly defined and involve fewer alternatives. Among the options being debated in the halls of Congress are expanding the capital gains tax, strengthening tax enforcement and taxing high net-worth individuals. There are sobering prospects for whether the latter two would either pass Congress or put a big dent in the deficit (see Other Options for Increasing Taxes). In this article we focus on “unrealized” capital gains, which could affect virtually all real estate investors.

Capital gains taxation

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Taxpayers now pay capital gains tax only when they sell an asset, such as stocks and real estate. For most taxpayers, long-term capital gains, ones generally held for a year or more, are taxed in the year of sale. For most real estate investors, the current capital gains tax rate is effectively 15% to 23.8%, depending on one’s household income. The proposal to raise additional revenue by taxing capital gains not yet realized is controversial, but proponents argue it’s a big potential source of revenue with seemingly limited disruption to the economy and most households. Evaluating the possibility of such a tax raises a string of questions. What effect would taxing unrealized gains have on the distribution of wealth and income? On the deficit and economic growth? On democratic government and voters? We examine who holds unrealized capital gains, the challenges of bringing them into the tax system and what difference it could make to the budget deficit.

First, Figure 1 shows the average unrealized gains per household, according to the latest Federal Reserve Board of Governors’ Survey of Consumer Finances (SCF). The 1% wealthiest households have by far the greatest gains per household, accounting for 48% of all cumulative unrealized gains in 2019. All told, the top 10% of households account for 83%. On the other hand, all households from the 90th percentile down are scarcely visible because, without the increases in the value of their personal residence, they barely make it onto the chart. Further, these results understate the concentration of capital gains at the top because the survey excludes the Forbes 400 wealthiest households.

Source: Federal Board of Governors’ Survey of Consumer Finance

Considered the definitive source of data for unrealized capital gains, the Fed’s Board of Governors conducts the SCF every three years using personal interviews to obtain detailed information on household finances. It obtains data on virtually all assets, with purchase cost and current value (thus, the gain), for each respondent household. The discussion here is exclusively focused on long-term capital gains. Some assets are exempt, including retirement funds, such as 401(k), IRA accounts, tax-exempt bonds, and, within limits, owner occupied personal residences. Similarly, some transactions are shielded, including like-kind exchanges, installment sales and tax-free reorganizations.

Estimating the impact

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Estimating the potential revenue from an unrealized capital gains tax requires some simple math on aggregate data provided in a few government reports. Figure 2 shows the steps we used to estimate the impact of taxing unrealized capital gains using the SCF to capture the average unrealized capital gains in each three-year period. This method suggests the government could collect an additional $201 billion by expanded capital gains taxation. This is about 13% of the Congressional Budget Office’s 2024 forecasted budget deficit of $1.6 trillion. Given that 83% of all the unrealized gains are concentrated in the top 10% of households, this expansion of capital gains taxes could generate at least a 10% deficit reduction without affecting a vast majority of voters.

Figure 2 – Estimating the Impact on the Budget Deficit

Per year by average households.

Year Cumulative Avg. Unrealized Gains per HH Annual Avg. Taxable Unrealized Gains per HH Annual Avg. Realized Capital Gains per HH
1992 $79,281 $0 $1,577
1995 $72,004 $0 $2,059
1998 $106,858 $6,173 $3,986
2001 $124,054 $5,732 $6,866
2004 $129,406 $1,784 $2,997
2007 $186,924 $19,173 $6,803
2010 $114,364 $0 $1,154
2013 $120,176 $0 $4,351
2016 $166,303 $0 $5,800
2019 $178,618 $0 $5,728
Total $32,862 $41,320

Doing the Math

How we determined the potential effect of an unrealized capital gains tax on the deficit.

  1. Ratio of unrealized gains ($32,862) to realized ($41,320): 80%
  2. 2024 CBO projection of all gains: $1,370
  3. Long-term portion of gains @ 92.4%: $1,266
  4. Estimated additional taxable gains @ 80% (from step a.): $1,006
  5. Estimated potential additional tax revenue @ 20% rate: $201
  6. 2024 CBO projected deficit: $1,571
  7. % 2024 potential deficit reduction (e/f): 12.8%

HH = households; 2019 dollars; billions USD

Sources: Federal Board of Governors’ Survey of Consumer Finance, Congressional Budget Office (CBO), Bergstrom Real Estate Center

Unrealized capital gains are a large part of concentrated wealth in general. Figure 3 shows unrealized gains in relation to total mean household net worth in 2019. There is a wide range of net worth from accumulated unrealized capital gains (excluding gains on a personal residence) depending on household income. This dramatizes the widely recognized situation that both accumulated unrecognized capital gains and household net worth are extremely concentrated in the top end of the household income distribution. The top 1% of households by income hold almost 30% of net worth while the top 5% hold 53%. By contrast, the lower half of the distribution virtually fails to register on the chart. There is one notable offset to this imbalance: Social Security and pension income, which may be thought of as a valuable quasi-asset. But the evidence from the SCF suggests that even this factor, like the value of a residence, tends to favor the higher end of the income distribution.

Excludes primary residence. Source: Federal Board of Governors’ Survey of Consumer Finance

Problems with the current tax

There are many constraints in targeting the capital gains tax. The first complication is its volatility. Note the variation in cumulative level of gains shown in Figure 1. Gains are sensitive to the business cycle and owners sell fewer assets if the tax rate on computed gains rise. Extensive research has shown that if “rate elasticity” is high enough, a rate increase could cause revenues to fall.

Tax revenues are volatile because owners can avoid the tax. One tactic is simply to hold the asset longer and use it as collateral for debt financing. A second tactic is never selling. At death, the heirs of the owner benefit from a special “step-up basis” provision in the law that allows the heirs to receive the asset with a new basis: the value at the time of bequest. Thus, all the decedent owner’s gain escapes taxation. A third avoidance tactic is to donate highly appreciated assets because a deduction is allowed for both the basis and the gain, giving the owner a deduction for the gain rather than a tax bill.

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Another problem follows from these tax avoidance options. They create a “lock-in” effect, causing assets to be held longer than is otherwise efficient for the economy. So, neutralizing these avoidance options presumably would make patterns of investment more productive for society. Finally, gains are not adjusted for inflation. So, the current law taxes owners on both true gain and price increases driven purely by inflation.

Challenges and benefits

The most widely discussed plan for implementing a broader capital gains tax would have two parts:

  • Mark to market: For actively traded assets — mostly stocks or bonds — marking to market would be used. That is, each year the change in value would be measured from the market, and a tax obligation would follow. What happens if value falls is a topic little discussed, but one response could be to allow full carryover of the loss to offset future gains.
  • Retrospective taxing: Other assets — such as real estate and closely held companies — would be taxed using a retrospective method. That is, the tax is paid only when the asset is sold, and the tax is computed retrospectively based on the actual sale price (or valued in the owner’s estate). For the intervening holding period, interest would be charged on the accumulated unpaid tax obligation. This plan also would end the step-up basis noted earlier.

There is ample cause for skepticism about the benefit of a broader capital gains tax. To begin, a significant share of the assets generating unrealized gains — closely held companies and real estate — are complex and thinly traded, and among the more difficult for tax computation and enforcement. Paying a tax on an unrealized gain could be problematic because these assets are illiquid or there’s a lack of adequate market information on value. It could be highly disruptive to sell part of a closely held business or property to pay the tax imposed. Many observers are less than sanguine about improving tax compliance with such assets. But these concerns may be of little interest to policymakers looking to increase revenues with minimal voting impact.

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Advocates of expanding capital gains taxes argue that they would have multiple positive economic effects. They would solve the current economic inefficiency in taxation of gains, namely the “lock-in” effect. This retention incentive would disappear because a sale would no longer affect the tax obligation. The step-up basis would give way to a carryover of the owner’s basis, and full tax on gains would follow. The resulting tax could be either a death tax on the owner’s estate or an inheritance tax for the heirs.

But there is stiff resistance to these changes from noncorporate business owners, real estate owners and noncorporate farm owners. They argue additional capital gains taxes would impose harm due to the illiquidity of their assets and the inability to make the tax payments without damaging the enterprise.

A widely used argument for not imposing a tax on unrealized capital gains is that reduced returns would diminish the incentive for investment, and therefore lessen economic growth. In a classic economy with perfect financial, regulatory and market information, this argument might be credible. However, empirical evidence supports policymakers’ dismissal of this position as it is yet to be shown that a change in capital gains taxation has affected economic growth. Economist William Gale of the Brookings Institute told a congressional committee last year that an analysis of tax cuts implemented by the Trump administration “provides another set of evidence that tax changes do not exert powerful influences on economic growth.” Further, if the avoidance options are neutralized, eliminating the propensity for “lock-in,” the effect of broader capital gains taxes arguably could be positive for growth.

Another concern is the treatment of inflation. As capital gains are more broadly taxed, the very legitimate argument for inflation adjustment will become more persuasive. Extracting taxes on gains that are driven purely by price index increases is hard to defend.

Keeping up with the tax debate

Altogether, problems of enforcement, risk of business disruptions and the issue of accounting for inflation, all diminish the prospect of increasing revenue from taxing of unrealized capital gains. Nevertheless, a growing number of policymakers are sounding an alarm that such a tax is needed to reduce the deficit. In addition to raising revenue, they argue taxing unrealized gains would improve economic efficiency, fairness in the distribution of income and wealth and the position of the middle class. Any real estate investor taking advantage of long-term investment deferral of gains should be aware this section of the tax code is vulnerable.

After all, talking about taxes is nothing new to the real estate community, which has engaged in perennial debates about issues such as carried interest and 1031 exchanges, mechanisms that allow investors to defer paying capital gains taxes. What is new is that these older debates are small in comparison to a potential elimination of all long-term gains tax deferral. The point is: Real estate investors should keep up with this policy debate.

Other Options for Increasing Taxes id="other-options"

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Taxing unrealized capital gains is just one of several alternatives being debated in the halls of Congress. Two others include strengthening tax enforcement and imposing a “wealth tax.”

Enforcement is a major concern in the U.S. tax system because it represents tax owed but not collected. The estimated gap between what is owed and what is paid is between $441 billion and $1 trillion per year. The problems range from taxes owed but not yet paid to widespread tax evasion. The concerns are particularly severe at the super-rich level where the complexity and the lack of IRS resources render federal auditing nearly nonexistent. Many informed observers doubt that increased enforcement could close much of the spiraling federal budget deficit. The Inflation Reduction Act of 2022 calls for spending $46 billion more on enforcement over the next 10 years, which would result in a $700 billion reduction in the gap over that decade. This would translate to an annual reduction of roughly $65 billion in the deficit, or, for 2024, 4.5%.

A wealth tax is also increasingly discussed by advocates for redistribution. U.S. Sens. Elizabeth Warren and Bernie Sanders have offered two separate Ultra-Millionaires Tax proposals. The Warren plan would impose a 2% annual tax on the wealth of taxpayers with $50 million or more in net worth (about 75,000 households) plus 3% on wealth above a $1 billion. The proposal is estimated to generate roughly $2.5 trillion in revenue over 10 years. This translates to a $250 billion annual deficit reduction, about 17% of the 2024 deficit. The Sanders plan starts at 1% for net wealth above $32 million and rises to 8% for net wealth over $10 billion. It claims to raise $2.6 trillion over 10 years, or 18% of the 2024 projected deficit. Despite its application in three European countries, there appears little prospect of the U.S. adopting such a tax anytime soon, though vigorous discussion continues.

Wayne Archer

Wayne Archer, Ph.D., is a University of Florida emeritus professor of real estate.