In his State of the Union message, President Obama called on Congress to raise taxes on the so-called “wealthy.” Most of the plan’s funding would come from an increase in capital gains taxes and an end to the step-up in basis for inherited wealth.
Mr. Obama’s proposal calls for imposing capital gains at death rather than allowing a basis step up when assets pass to heirs, as under current law. The first $100,000 in gains would be exempt for single people ($200,000 for couples), with an additional $500,000 exemption for the home. There would be special rules to protect small businesses, and gifts to charity would be exempt.
This is a substantial departure from the long standing “step-up” in basis tax rule. This is a commonly overlooked tax benefit that can seriously help to minimize capital gain taxes that might otherwise have been owed when someone inherits assets from another (i.e. – parent, spouse, etc.).
So what is a “step-up in basis” and how does it work?
Your basis is usually what you paid for the asset. According to the IRS, a capital gain or loss is the difference between your basis and the amount you get when you sell an asset. In other words, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain.
For example, if you had purchased stock many years ago for $10 a share and sold it today for $75 a share, the $65 per share gain would have to be taxed. Same rules apply for real estate as well, subject to special rules for the sale of a personal residence.
These capital gains taxes will vary depending on whether they are considered short-term gains (assets held less than one year and taxed as ordinary income) or long-term gains (assets held for more than one year and taxed between 0 percent (if income below $37,450) and 20 percent, depending on your income level).
While capital gains taxes can be significant, it is possible to avoid this tax altogether — let your heirs inherit the asset. When someone inherits an asset, the cost basis of the asset is “stepped up to value” on the date of death.
For example, let’s assume that an elderly parent leaves a home to their children that is valued at $400,000 on the date they pass away and the cost basis of the property is only $100,000. (e.g. – the home was purchased 25 years ago). Because of the step-up in basis rule, the beneficiaries will not be responsible for capital gains tax on $300,000 worth of gains.
Since they received a step-up in basis, they will only be responsible for gains that might occur from the point they inherit the asset and then sell it. For example, if the beneficiaries later sell the home for $425,000, only the $25,000 is considered a gain as it represents the increase in value after the original owner passed away.
The White House proposal would also raise the top capital-gains tax rate to 28 percent from 23.8 percent for couples with incomes above $500,000 a year.
It is highly unlikely that Congress will approve this proposed tax rule change. It is believed that this proposal for a significant tax increase is to be used a leverage against an anticipated request by Congress for the outright repeal of the Death Tax, which was supposed to occur in 2011 but did not materialize. See attached Bloomberg report with detailed breakdown of this legislative posturing.