President Biden has proposed some drastic tax law changes. These changes include altering the step-up in basis tax break, capping gains that can be deferred, as well as potentially lowering the estate tax exemption.
PROPOSED CHANGES TO STEP-UP IN BASIS AND INCREASED CAPITAL GAINS TAXES
The American Families Plan as proposed by President Biden details two fundamental changes:
- instead of assets receiving a “step-up in basis,” after death, unrealized gains will receive a small threshold exemption and then become subject to federal income tax; and
- marginal capital gains tax rates may be increased to as high as 39.6%.
As proposed, the exemption level would be $1 million per individual plus $250,000 for a primary residence. For couples, the exemption would double to $2 million plus $500,000 for the primary residence. Other exemptions may apply to assets donated to charities and family-owned business.
For example, imagine that Mr. Decedent, a single man, bought a house for $500,000 and stocks for $1 million. At the time of his death, the value of these assets doubled, increasing in value by $1.5 million.
Under existing law, the income-tax rate for these gains would be zero. Mr. Decedent’s heirs would benefit from a step-up in basis, meaning that after Mr. Decedent passed away, the value would step up to its current value for purposes of measuring the taxable gain.
However, under President Biden’s proposal, Mr. Decedent’s estate would receive a $1,250,000 exemption ($1 million plus $250,000 for the house) and then be taxed at the top rate of 39.6% for the remainder of gains. Therefore, Mr. Decedent’s estate would be responsible for $99,000 in taxation (39.6% of $250,000). This might be very problematic for those who do not wish to sell inherited assets in order to secure funds to pay taxes.
PROPOSED CHANGES TO IRC SECTION 1031 LIKE-KIND EXCHANGE RULES
Another proposal would change the income tax rules on the sale of appreciated real property. Currently, under Section 1031 of the Internal Revenue Code, if you sell a piece of appreciated real property, you can roll that appreciation into a second piece of property and defer the income tax.
President Biden has proposed capping the deferral amount on these “like-kind exchanges” at $500,000. Effectively, by placing a cap on income tax deferrals and altering the rules for a step up in basis after death, people would no longer be able to permanently defer and ultimately avoid income tax by holding onto property until they die.
PROPOSED CHANGES TO THE ESTATE TAX
Another proposed change would involve lowering the estate tax exemption. The exemption amount is currently set at $11.7 million per person ($23.4 million per couple) and the Biden administration has previously suggested lowering it to 2009 levels, when it was $3.5 million per person ($7 million per couple) with a top estate tax rate of 45% for assets exceeding the exemption.
For example, under current law, if Mr. Decedent’s combined assets totaled $10 million, upon his death his estate would not owe any estate tax because it falls below the $11.7 million exemption. However, if the estate tax were lowered to $3.5 million and the tax rate increased to 45%, Mr. Decedent’s estate would be responsible for an additional $2,925,000 in estate tax (45% of $6.5 million).
There is no guarantee that the above proposals will become law and even if they do, they may look very different by the time they are enacted. If history is any indicator, bills that increase taxes on the wealthy face a long and difficult journey and many do not survive.
The future of tax policy is uncertain but the best way to avoid unnecessary taxation is to ensure your current estate plan takes advantage of existing law and you are well informed should changes occur. If you would like to discuss tax planning and your existing estate plan, please contact us.