In recent years, tax policy has tended to change depending on which political party held the reins in Washington, D.C. These swings are problematic for people making long-term financial decisions; The increasingly dynamic nature of tax law offers a good reason to review your estate plan regularly, and at a minimum, every few years. (It’s a good idea to do that regardless of tax laws, in case there are changes in your assets, beneficiaries, or other circumstances.)
January 2021 saw a new presidential administration ushered in, and along with it, Democratic majorities in the House and Senate. With Democrats in power in the White House and Congress, there is an increased likelihood that their party will be able to pass new legislation—including tax legislation. While there is no guarantee that any of the potential changes being talked about will occur, it is wise to know what could happen and to plan for it.
One possible change coming involves a change in rule regarding the the “step-up” in tax basis. When you buy an asset, your tax basis in the item is what you paid for it. For instance, if you bought stock at $10 per share and sold it for $50 per share, you would pay capital gains tax on the difference between the sale price and your basis, or $40.
But let’s say that instead of selling that stock when it hits $50 per share, you hang onto it for the rest of your life. At the time of your death, your child inherits the stock when it is worth $100 per share. If she sells it then, what would her capital gains be? The obvious answer is “$90 per share.” But thanks to the step-up in basis, the correct answer is “Zero.”
The step-up in basis rule means that someone who inherits an asset has a basis equal to the fair market value as of the time of the death of the person from whom they inherited it. Instead of taking your $10 basis in the asset, your child would have a basis of $100 per share. What’s more, if she held onto the asset and her child inherited the stock when it was worth $200 per share, that child would take a stepped-up basis of $200. If he promptly sold the shares, he would not pay a single centin capital gains tax under current law, even though the stock was worth 20 times what you originally paid for it.
The operative words in that last sentence are “under current law.” There has been discussion of the Biden administration eliminating the step-up in basis. In the scenario above, that could result in your child taking your $10 per share basis in the stock, and your grandchild taking the same $10 basis on any shares inherited from your child. If the stock was valued at $200 per share when sold, your grandchild would owe capital gains tax on $190 per share.
Under current tax law, as long as an asset is passed down from generation to generation without being sold, it can keep increasing in value and no capital gains tax is owed on it because the owner has not realized any gain on the asset.
Another proposed change to tax law could change this long-standing rule by making death a taxable event. A tax could be levied on unrealized appreciation of an asset at the time of the owner’s death. The estate would be required to pay the tax just as if the deceased had sold the asset just prior to death. Generational wealth transfer which previously went untaxed would become a source of revenue for the federal government. In the scenario above, it would not matter whether your child or grandchild sold the stock; the transfer at the time of your death or your child’s death would trigger the tax.
Thinking about doing an end-run around this possibility by giving the asset to your child while you’re still alive? Under proposed changes to the law, the asset’s appreciation would still be subject to capital gains tax.
Currently, long-term capital gains (those on assets held longer than a year) are taxed at a top rate of 20% depending on the income level of the seller. Under proposed changes, capital gains would be subject to the same tax rate as ordinary income for households earning more than one million dollars annually.
In addition, the top tax rate for ordinary income would increase from its current rate of 37% to 39.6%. In other words, capital gains could be taxed not only more frequently, but at almost double their current rate. This could be catastrophic for families passing down small businesses or family farms.
Very few households currently owe any estate tax, owing in large part to the amount of the federal estate and gift tax exemption. As part of Donald Trump’s Tax Cuts and Jobs Act (TCJA), this exemption amount reached record highs: indexed for inflation, the exemption amount for a single filer is $11.7 million, and twice that for a married couple.
What this means is that an individual with an estate valued at up to $11.7 million can leave that amount to heirs without triggering estate tax. If that individual’s estate were worth $12 million, only $300,000 of that amount would be taxable.
As part of the TCJA, these high exemption amounts are due to “sunset” as of December 31, 2025, reverting to their pre-TCJA levels. Under the Biden administration, however, exemption rates could drop sooner, leaving more estates vulnerable to paying estate tax.
As noted at the beginning of this blog post, planning for tax changes is a bit like planning to hit a moving target. None of these proposed tax changes have happened, and they may not happen. And even if they do happen, the laws may very well change again under a new administration. We are keeping a close eye on developments and will keep our clients posted. In the meantime, if you have concerns about what estate tax changes could mean for you, we invite you to contact one of our Ohio office locations to schedule a conversation.