Aside from annual inflation adjustments, there aren't any significant capital gains tax changes on tap for 2021. Long-term gains still get taxed at rates of 0%, 15%, or 20%, depending on the taxpayer's income, while short-term capital gains on assets held for a year or less are considered ordinary income for tax purposes.
However, that's not to say that capital gains tax can't change this year. In fact, if the incoming Biden administration gets its way, that's exactly what could happen, especially now that both the House and Senate will be under Democratic control.
Could capital gains taxes increase in 2021?
Biden's tax plan called for a hike in the long-term capital gains tax rate, but only for the richest Americans. Specifically, the current top capital gains rate is 23.8% (20% plus a 3.8% net investment income credit on high earners).
Biden's plan is to impose a top long-term capital gains tax rate of 39.6% -- the same top tax rate he's proposing for ordinary income. However, this would only apply to Americans with income of $1 million or greater. And this is before the 3.8% surtax for net investment income. Including that, this could produce an effective long-term capital gains rate of 43.4% for the highest earners in the country.
It's entirely possible that a capital gains tax hike could be passed retroactive to January 1, 2021. However, history tells us that isn't the most likely scenario. As one recent example, the Tax Cuts and Jobs Act (President Trump's tax cuts) didn't go into effect until the 2018 tax year, the first full year Trump was in office. Similarly, while Democratic control of the House and Senate make Biden's capital gains plan much more achievable, it likely wouldn't go into effect until 2022 at the earliest.
1031 exchanges could be in jeopardy
It isn't just the possibility of higher capital gains tax rates that's troublesome to real estate investors -- the popular method for avoiding them could be going away.
Like-kind exchanges of real estate, also known as 1031 exchanges, are a popular way for real estate investors to defer paying capital gains tax upon the profitable sale of a property. You can read our guide to 1031 exchanges for more information, but the general idea is that if you use the proceeds from the sale of a property to purchase another one, you can defer any capital gains until the newly acquired property is sold.
President-elect Biden's tax plan specifically calls for eliminating tax breaks for real estate investors. Although it didn't mention 1031 exchanges in particular, that's likely a big part of what it's referring to. It's estimated 1031 exchanges cost the government as much as $4 billion in potential tax revenue each year. Elimination of 1031 exchanges would likely cause many investors to think twice before selling properties.
The Millionacres bottom line
The incoming Biden administration has certainly suggested a couple of major changes to the capital gains taxes investors pay, as well as to the 1031 exchanges real estate investors commonly use to defer or avoid paying them. The most likely scenario is that it will be at least 2022 before we see any of these actually signed into law (if ever), but it's certainly important for real estate investors to keep up with the latest developments.