Investing

Stepped Up Basis Reform: Biden’s Middle-Class Tax Hike?

President Joe Biden campaigned on a promise to not raise taxes on middle-class Americans. But a little-known provision in his proposed tax reforms could do just that.

One way the Biden tax plan may try to raise revenue to fund the administration’s $3 trillion infrastructure bill is by changing the way capital gains taxes are administered at death.

Right now when someone inherits property or investments, they aren’t taxed on the appreciation that took place before they gained control of the asset. Biden’s plan could change that, making the inheritor liable for taxes on all of the gains, including the ones that accrued before they took ownership.

Major Biden tax hikes eyed for next bill (not final) include:

– Corporate rate 21->28%
– Global min tax to 21%
– Top income rate to 39.6%
– End fossil fuel subsidies
– Tax investment gains > $1M as wage income
– Tax assets passed on at death

NO to SALThttps://t.co/SCpSHH5OHr

— Jeff Stein (@JStein_WaPo) March 23, 2021

Senators Cory Booker (D-NJ), Chris Van Hollen (D-MD), Bernie Sanders (I-VT), Sheldon Whitehouse (D-RI) and Elizabeth Warren (D-MA) have announced a bill designed to close the stepped up basis tax loophole

You might not have much sympathy for wealthy heirs who may suddenly have to “pay their fair share,” as Biden puts it. Yet this reform, unlike some of the administration’s other proposed tax plans, could hit middle-class Americans squarely in the wallet. Should the rule change, it might even affect you.

What Is Stepped Up Basis?

When people inherit assets, a tax rule called stepped up basis—also referred to as a step up in basis—provides potentially huge benefits.

Assets that are passed down in a will generally have gained in value since the deceased purchased them, potentially decades ago. These capital gains are taxable when the asset is eventually sold by the inheritor. Stepped up basis minimizes the tax bill.

In the world of taxes and accounting, basis is where you start calculating capital gains taxes. Think of basis like the asset’s purchase price: You owe capital gains taxes on the value gained above the basis. The stepped up basis means that inherited assets have their basis reset to a present fair market value at the moment they are passed on to an inheritor in a will.

This is currently enshrined in Section 1014 of the Internal Revenue Code, which states the basis of an inherited asset rises to “the fair market value of the property at the date of the decedent’s death.”

Eliminating Stepped Up Basis Could Be a Middle-Class Tax Hike

It’s not hard to see how eliminating the stepped up basis rule could turn into a middle-class tax hike, for all intents and purposes. Here’s an example of how that could work.

Anne is a single middle school teacher living alone in Austin, Texas, and takes home $60,000 a year, making her a typical average American. Remember, Biden has promised not to raise taxes on those earning less than $400,000, so Anne doesn’t pay much mind when the administration passes a series of tax increases.

But when Anne’s bachelor uncle suddenly passes away, he leaves her his Tampa Bay condo. Having no desire to live in Florida, Anne immediately decides to sell the condo, which fetches $600,000, a decent return on the $100,000 price her uncle paid for it two decades ago.

What would Anne owe Uncle Sam? If she were to sell the house under the current rules, she would owe little or nothing. The basis for the condo would have been stepped up when she inherited it from her uncle—from $100,000 to fair market value, which would have been the same or very close to the $600,000 sale price.

If Biden were to nix stepped up basis, then she could owe significant taxes on the inherited property. How much?

  • Anne’s gain: $500,000
  • Anne’s long-term capital gain rate: 20%
  • Anne’s net investment income tax rate: 3.8%
  • Anne’s total tax bill on the sale: $89,327.50

Remember, Anne’s not a high earner, she’s a middle school teacher. If Biden eliminates stepped up basis before, she could see her taxes on the sale of her uncle’s inherited home jump from $0 to nearly $90,000. That’s a middle-class tax hike.

Some Democrats are wary of scenarios like this one. Senator Booker and his co-sponsors have proposed allowing a $1 million per person exemption, significantly higher than what the Obama administration called for in 2015. It’d be large enough to bring Anne’s tax liability back down to zero.

Why End Stepped Up Basis?

It’s not surprising the Biden administration is looking closely at this particular precinct of the tax code: Dumping stepped up basis could raise a ton of money. And it’s hardly the first time an administration has flirted with axing stepped up basis. Efforts were made to change this tax rule in 1976, 2001 and 2015, according to the Tax Policy Center.

“Getting rid of stepped up basis is seen as a big revenue raiser,” said Dr. Will McBride, vice president for federal tax and economic policy at the Tax Foundation.

In 2015, the Obama administration proposed closing the loophole while carving out an exemption of $200,000 in gains for couples and $100,000 in gains for singles. Together with an increase of the top bracket for long-term capital gains to 28% from 20%, Obama’s plan would have brought in more than an estimated $200 billion over 10 years.

That said, boosting the top rate on capital gains won’t automatically bring the Treasury the extra revenue it needs. Individuals can just hold onto their gains for longer, never actually realizing them and thus delaying being taxed.

But ending stepped-up basis, or even taxing an asset’s accrued gains when the owner dies, would expedite dollars into the government’s coffers. And most of those affected will be among the nation’s richest households, making it a more politically palatable way for Biden to pay for his agenda.

What Should You Do Now?

Remember, nothing has changed just yet, and a legislative proposal is just that: a proposal.

The prospect of raising taxes as the economy continues to recover from the Covid-19 recession will inflame tempers on Capitol Hill, and controversial legislation should have a difficult time in an evenly divided Senate. That means even if stepped-up basis ends up in lawmakers’ crosshairs, it may not be completely liquidated.

“I have a hard time believing it will be completely eliminated,” said Joseph Velkos, a Key Private Bank trust tax director in Cleveland, Ohio. “If it is, it’ll affect many more people, including those making less than $400,000 a year.”

If you’re planning out your estate, or expect to be the beneficiary of an inheritance, there are a few things you can do to prepare for whatever changes Congress makes to the tax code.

Gather Documentation

It can be difficult to keep track of an asset’s cost basis, which is one reason why the current rule exists. For instance, Anne’s basis on her uncle’s home would be higher if she had documentation proving he had paid for a new kitchen. The same is true for dividends and interest that’s reinvested in a portfolio.

That may sound daunting, which is why Ed Slott, a certified public accountant (CPA) and well-known retirement expert, is dubious any such bill will ultimately pass.

“It’s a tax record-keeping nightmare,” said Slott. “It’ll be impossible to figure out the basis, both original cost and improvements, for Grandma Moses’s home.” In response to that concern, some advocates for eliminating stepped up basis suggest a flat rate, such as 10% of the sale price.

In any case, asset owners, and those who stand to inherit it, should start poking around for documentation.

Think Creatively

Changing the stepped-up basis rule could cause a ripple effect. No one, after all, will sit around waiting to pay taxes.

For instance, let’s take Anne. She could exclude $250,000 in gains from Uncle Sam’s talons if she both owned her condo and lived in it as her primary residence for 24 months out of the last five years. Perhaps she’d reconsider living in Tampa a while to significantly lower her tax burden?

Mike Piper, a St. Louis-based CPA, foresees other moves. For instance, it may make less sense to own stocks in taxable accounts if your kin will owe taxes on all gains. That could, “mean a shift back towards bonds, particularly municipal bonds, being the primary option for taxable accounts,” he said.

Once you’re in retirement, Piper noted, you might prioritize spending down your taxable account since it’d be better for your heirs to inherit a higher portion of funds in your individual retirement account (IRA).

Folks might also make more use of tax avoidance strategies. Right now you can donate an appreciated asset to a qualified charitable organization and receive a deduction on the full market value, said Piper, thereby avoiding taxes on the gains.

Of course richer households could employ a slew of other options, including trusts, to pass assets to heirs while paying as little as tax as possible.

Stay Connected

Velkos received a lot of client calls during the election, inquiring what might happen if Biden were to win. He advised his clients to start gaming out plans now to be ready for whatever comes out of Congress.

“Start the conversations with your advisor, especially if you have some level of wealth,” Velkos said. “Lay out the different scenarios and what you might do down the road.”

If Anne’s uncle knows that she’ll likely face a big tax bill, he might consider adding a life insurance policy to his estate planning to help her cover costs,for instance.

Talk to any tax lawyer and they’ll tell you the rules of the road are always changing. The key is to know how to drive even if you don’t have a Porsche.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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