During the 2020 presidential campaign, media coverage of the candidates’ tax plans was largely limited to income tax, most notably Joe Biden’s assurances that families earning less than $400,000 annually would not see their income tax increase.
But taxes encompass much more than income tax, and there is one aspect of now-President Biden’s tax plan that is a source of concern to investors, financial advisors, and estate attorneys: the proposed elimination of the step-up in basis.
When an asset, like a stock or piece of real estate, appreciates in value, that appreciation is “realized” at the time the owner sells it, resulting in capital gains. For instance, if you bought stock 20 years ago for $5,000, and you sell that stock today for $100,000, you will realize capital gains of $95,000—the value of the stocks, minus your “basis:” what you paid for the stock. You would pay taxes on those gains.
However, if you were to die holding those stocks, and your adult child inherited them from you, she would (under current law) take them with a “step-up” in basis. In other words, her basis in the stock would be the fair market value of the stock at the time of your death, rather than at the time of your purchase of the investment. If she turned around and sold them immediately, she would owe $0 in capital gains tax. If you had transferred the stock to your child the day before your death, she would have a “carryover basis.” In other words, she would have the same basis in the stock that you did: $5,000.
Stocks are not the only assets that are subject to capital gains tax. Other “capital assets,” such as bonds, jewelry, art collections, coin collections, and real estate, may also be subject to the tax. Some families might not buy and hold stock or other investments for decades. But many have a home or family farm that has been in the family a long time and which has appreciated significantly, so the step-up in basis helps them, too. If your parents bought a home in 1975 for $50,000, and you inherited it in 2020 when it was valued at $300,000, you have been a beneficiary of the step-up in basis.
While it may not have received much coverage during the campaign, President Biden’s proposed elimination or reduction of the step-up in basis should definitely be on people’s radar screen now.
In addition to increasing the tax burden, the elimination of the step-up in basis would also increase the record-keeping burden for owners of capital assets.
In the stock example above, if the step-up in basis were eliminated, your child would inherit your $5,000 basis along with the stock, resulting in $95,000 in capital gains if sold immediately (and more if she allowed the stock to appreciate further after she inherited it). Heirs of individuals leaving more extensive investment portfolios would of course, be hit even harder. In addition to increasing the tax burden, the elimination of the step-up in basis would also increase the record-keeping burden for owners of capital assets.
Then there are issues involving owners of small businesses and family farms. Let’s say you started a business in your garage when your kids were small. It’s now worth five million dollars. You plan to leave the family business to your kids. They won’t receive a step-up in basis, but that’s fine as long as they don’t sell the business, right? Unfortunately, there may be some bad news on that front, too.
Part of the discussion of eliminating the step-up in basis focuses on the fact that when an heir or beneficiary sells an asset, they would pay more in capital gains tax—perhaps significantly more. But there is another tax proposal afoot that could subject the heir or beneficiary to increased taxes without the sale of the capital asset.
The Biden plan also proposes subjecting assets to taxation on unrealized gain at the time of transfer. In plain English, that means that tax becomes due when a person receives an asset, not when they sell it. In the example of the family business above, your business that had a $0 basis but is now worth five million dollars would be taxed to your kids when they receive it.
What happens if they don’t have the liquid assets to pay taxes on a sudden five million dollar gain? They may have to liquidate part of the business—or sell the business altogether. The same could be true for those inheriting family farms or homes.
As if this isn’t bad enough, it could get even worse. Currently, the long-term capital gain rate is 20% for individuals with taxable income in excess of $441,451 (or $496,601 for married couples filing jointly). Under President Biden’s plan, long-term capital gains would be subject to the same rate of taxation as ordinary income for incomes greater than one million dollars. This could be disastrous for people inheriting small businesses, family farms, or stock portfolios.
None of these changes have come to pass, and they may not. Sweeping tax policy pronouncements during a campaign may not come to fruition when the details must actually be hammered out by legislators. Threatened eliminations of the step-up in basis in the past have not materialized in the final version of legislation. But because the proposal to eliminate step-up in basis is on the table, you should be aware of it.
Should this policy become law, there may be things you can do to reduce your heirs’ tax burden. For instance, rather than leaving capital assets like stock to your heirs and cash to your favorite charities, you might donate the stock instead. However, these decisions can have far-reaching ramifications, so you should never change your estate plan before consulting with an experienced estate planning attorney. With offices in Northville and Brighton, we invite you to contact our law office for a consultation.