In our last newsletter, we forecast potential changes to estate taxes due to the majority maintained by the Democrats in the House of Representatives and the slight advantage the Democrats have in the Senate because Vice President Harris, a Democrat, casts the tie-breaking vote. The President recently released his American Family Plan (AFP) which includes a number of proposed changes that will impact taxes on our readers’ estates.
If passed, the AFP would, at death, impose a tax on unrealized capital gains exceeding $1 million. Also, the capital gain would be taxed as ordinary income. How do these changes affect you? Presently, appreciated assets are taxed only upon their sale. Assume you had purchased stock for $100,000.00 ten years ago which has grown in value to $500,000.00. If that stock were sold today, you would realize a capital gain of $400,000.00. It would be taxed as a long term capital gain because you owned it for more than one year. As a result, you would be taxed at a special lower tax rate of 20%, resulting in a tax bill of $80,000.00. Under the AFP, the capital gain on this sale will be treated as ordinary income and be taxed at a much higher rate: as high as 43.4% (39.6% ordinary income tax plus 3.8% investment income tax) or $175,600, an increase of over $95,000.00.
The “basis” of an asset is the value used to determine the capital gain. With stock, the basis is the purchase price, $100,000.00 in the example used above. For homes or other real property, the basis is the purchase price plus the cost of capital improvements. Capital improvements include adding an in-ground pool or an extension on the property, finishing a basement that was unfinished, upgrading a kitchen or bathroom and replacing windows. Appliances purchased for the new kitchen would not be considered a capital improvement. Currently, capital gains tax is due when the property is sold. That does not change under the AFP. However, what if you gift the appreciated stock to a child or some other person? Under the current rules, the recipient’s basis for the gift is the lower of the fair market value or the gift-giver’s basis. So, in the example above, the child receiving the appreciated stock would stand in the shoes of the stockgiving parent and have the same basis — $100,000.00. If the child sells the stock, the child owes capital gains tax on the appreciation of $400,000.00.
Under the AFP as currently proposed, the mere transfer of the appreciated asset will result in capital gains tax whether or not the asset is sold. This means that if the AFP passes, the child receiving the $500,000.00 gift of stock will owe tax of more than $95,000.00 immediately, even if none of the stock has been liquidated! Fortunately, most readers will not be affected by this potential immediate tax because the AFP only imposes the tax on unrealized capital gains worth over $1 million.
Currently, persons who hold on to their appreciated assets until death receive a “tax gift” from the government. The basis of their appreciated assets step-up to their fair market value as of the date of death of the owner. Assume that the stock discussed above is retained by the parent, continues to appreciate in value and is worth $600,000.00 at the parent’s death. That becomes the new basis. If the stock had been sold the day before death, the capital gain would be $500,000.00 and the parent would have been liable for $100,000.00 in capital gains tax. However, no tax would be due if the stock is sold for $600,000.00 after the parent’s death because the new stepped-up basis is $600,000.00 and there would be no taxable gain realized from the sale (sales price of $600,000.00 less stepped-up basis of $600,000.00 equals zero profit). This saves the family $100,000.00. For this reason, under current law, a much more favorable tax treatment results if the appreciated asset passes as the result of the owner’s death.
Unfortunately, the AFP also includes a drastic change to the “stepup in basis” rules. The AFP delivers a triple whammy. It eliminates the stepup in basis, the death of parent results in a transfer of the asset that will cause a tax to be due, and the appreciation will be treated as ordinary income. So, the stock worth $600,000.00 that had a basis of $100,000.00 could result in a taxable gain of $500,000.00 and be taxed as high as 43.4% resulting in a tax of $217,000.00.
The change in the step-up in basis rules under the AFP also creates an administrative nightmare. How many of us retain the records that prove the basis of our appreciated assets? Stocks may be purchased over a period of time at different price points. Companies whose stock we own could have been taken over by other companies and new shares issued. We may have purchased the stock through one brokerage house but later transferred the account to a new brokerage. How do we identify the dates and purchase prices of each of the shares owned? What if a child must calculate the basis because he or she is handling the affairs of an incapacitated parent? How will that child identify the purchase date for these stocks? Under the existing law, maintaining accurate and complete records relating to the purchase of appreciated assets was less important if the appreciated assets received an automatic step-up in basis at the death of the owner. The basis at death is readily ascertainable — it is the fair market value as of the date of death.
A further issue concerns the fact that the AFP does not specify an effective date in the proposal. It is possible that the changes could be retroactive to January 1, 2021. This would cause transactions that had no tax implications when made to result in a significant unforeseen tax.
As disturbing as these issues seem, passage of the AFP in its current form is questionable because the balance of power in the Senate is so tenuous and the Senate Republicans are opposed to the AFP. No doubt, there will be more to follow. In the meantime, this is an excellent reason to schedule a meeting with us to review your estate plan to ensure that your wishes are incorporated or, if you have not implemented a plan, to put one in place for your peace of mind and the protection of your loved ones.