There’s a lot of chatter lately about the impact of President Biden’s proposed tax legislation and economic agenda—and perhaps rightly so. We’ve recently learned more details about what’s included in the American Families Plan, and the tax implications are largely targeted at high-income earners and corporations.
There are two primary areas to be concerned about:
Estate tax changes
- Elimination of the step-up in basis
- Lower exemption amounts
- Increased estate tax rates
Capital gains changes
- Increase in capital gains tax rates
- Elimination of the 1031 exchange for real estate
Let’s take a look at the details.
Estate tax changes
There are a few pieces to the estate tax changes. The new estate tax proposal includes removal of the asset step-up in basis in excess of $1M, a reduction of the estate exemption, and increased estate tax rates. These changes are going to have a significant impact on families.
Elimination of the step-up in basis
A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis to minimize the beneficiary’s capital gains tax.
For example, let’s say you own a family business valued at $6M, with a basis of $100,000. If your heirs are going to continue to run the business, they will be exempt from paying capital gains tax at your death. However, if they go to sell the business later, or they don’t plan on running the business, they would be subject to capital gains tax when they sell.
Based on how the rule is currently proposed, there would be a $1M exemption, so if they were to sell after your death, they would owe capital gains on $4.9M ($6M less $100,000 basis less $1M exemption). They may also owe estate tax, eroding the value even further. This will apply to family farms, as well, who often own expensive equipment that has been fully depreciated.
Another example is if you own a family home that you want to keep in the family that has increased in value since purchase. Current legislation allows for a step-up in basis, but new legislation may require capital gains tax to be paid, forcing the family to to sell the property if they cannot afford the taxes.
This will require families to plan ahead more than ever if their goal is to preserve wealth.
Lower exemption amounts
Today, we have a record-high estate tax exemption, which allows an individual to gift or bequeath up to $11.7 million without your heir incurring tax ($23.4 million for married couples). New legislation could reduce this exemption to $3.5 million ($7 million for couples).
Increased estate taxes
In addition to eliminating the step-up in basis and reducing exemptions, new legislation could increase estate tax rates—potentially up to 45%. In this case, an additional 5% of your estate assets may be turned over to the IRS compared to today’s rates.
Capital gains changes
Changes to capital gains come in two forms: an increase in capital gains tax rates and elimination of the 1031 exchange for real estate.
Increase in capital gains tax rates
For Americans earning $1M or more per year, the American Families Plan proposes capital gains rates increase to ordinary income rates. The proposal also includes increasing top income tax bracket from 37% to 39.6%.
You may think that you do not make over $1M per year so it should not impact you. However, this will be a significant hit to those selling businesses or who may receive a large amount of their compensation in company stock.
Previously, a married couple earning $1M per year would pay 23.8% in tax (20% long-term capital gains tax + 3.8% net investment income tax). Now, if the legislation passes, this same couple would pay 43.4% (39.6% ordinary income tax + 3.8% net investment income tax).
That’s almost double—but it’s also a worst-case scenario. Most people don’t believe the capital gains tax will be changed to an ordinary income tax rate. It will likely fall somewhere in the middle, such as the previous 28% tax rate for higher income earners.
Elimination of 1031 exchange
The 1031 exchange has allowed real estate investors to preserve their investment value by deferring capital gains tax when making a “like kind” exchange to a new property. The step-up in basis at death allowed many of these investors to avoid all capital gains tax on real estate in the past.
The current proposal eliminates the deferral of tax on “like-kind” exchanges of investment real estate for gains greater than $500,000, which would be a huge change.
Financial planning can mitigate the impact of new legislation
There are ways to minimize these tax increases if you plan properly. For example, you can remove some assets from your estate by taking advantage of a spousal lifetime access trust (SLAT). This would not protect your heirs from capital gains taxes, but would protect them from estate taxes.
Here are a few other strategies to consider:
- Donate highly appreciated assets to charity or to a Donor Advised Fund. This allows 100% of your donation to be used by the charity and avoids paying capital gains tax. Contributions to a Donor Advised Fund allows you to avoid capital gains tax and you can also reduce your taxable income.
- Sell when your income is lower. The easiest way to avoid a capital gain is to not sell the asset and defer the sale into a year where your taxable income is low enough to stay under the $1 million threshold.
- Sell the asset over time. If selling the asset itself would be the reason that you exceed the $1 million threshold, sell it over time, in smaller quantities.
- Take Gains in 2021. If this proposal passes, it is likely not to go into effect until 2022. You may consider taking some gains in 2021 at lower rates.
- Use QCDs in place of RMDs. Reduce your income by making Qualified Charitable Distributions (QCDs) from your IRA to your favorite charities in place of your Required Minimum Distribution (RMD).
- Consider Roth conversions. Convert tax-deferred IRA assets to Roth, paying taxes at lower rates today.
- Life insurance. We are likely to see an increase in life insurance to pay these higher taxes and preserve family homes, farms, etc. Holding the life insurance in an irrevocable trust would protect it from estate taxes.
Keep in mind that taxes are one of those things that aren’t quite even for everyone.
Depending on where you live, tax changes may impact your financial situation differently. For example, making $500,000 in Exeter, NH goes a lot farther than in Los Angeles. Subsequently, an increase in taxes will have more of an impact on the person in the city with the higher cost of living. This may prompt people to move to a city where their money can go further.
At the end of the day, the American Families Plan is still just a proposal—it will likely change as it makes its way through Congress. However, now is the time to be prepared and start planning to mitigate its impact on your estate.