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

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

President Joe Biden campaigned on a promise not to raise taxes on middle-class Americans. But a little-known provision in his big social programs bill could do just that.

Tucked away in the American Families Plan, is a proposal to change the way capital gains taxes are paid on estates when people pass away. This seemingly small revision to a tax rule called stepped up basis could cause average Americans to pay more to Uncle Sam than they would under the current tax regime, in addition to upending estate planning for the nation’s affluent and uber-wealthy.

“Our clients love paying more in taxes,” joked Mallon FitzPatrick, managing director at Robertson Stephens Wealth Management. “They’re calling all the time.”

The debate surrounding the measure shows just how difficult it can be to raise enough tax revenue solely on the most well-off to fund beefed-up spending on social programs without also hitting the wallets of those lower down on the income ladder.

While this bill is far from becoming law, there are some steps you should take right now to get a handle on your situation.

What Is Stepped Up Basis?

But first, a refresher: When people inherit assets, stepped up basis—also referred to as a step up in basis—provides big benefits.

Inherited assets have usually gained in value since the deceased purchased them (potentially decades in the past). These capital gains are taxable when the asset is eventually sold by the inheritor. Stepped up basis can minimize the tax bill.

Basis is a key concept to understand here. Let’s say you bought a bunch of stock for $100,000 and a few years later sold it for $250,000. To understand how much you’d owe in capital gains taxes, you need to know your basis, or what you originally paid for the stock. It’s pretty simple in this example: Your basis is $100,000, and the taxable capital gain is $150,000.

For the better part of the past 100 years, the basis of an inherited asset is raised—stepped up, as it were—to the asset’s fair market value at the time of the original owner’s death. So let’s say you held on to the stock and passed it down to your heirs as part of your estate.

After a few decades, it’s now worth $500,000. If you were to die and pass down the stock to your child, the basis would be stepped up from $100,000 to $500,000, equal to its current fair market value. Future taxes are then calculated based on this new value, saving your heirs potentially huge amounts of capital gains taxes.

This provision 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.”

Practically speaking, this means if your child immediately sells the stock, they would own no capital gains taxes on the transaction. But if they waited a few years to sell, and the stock gained in value to $600,000, they would owe capital gains taxes on $100,000—that’s the difference between the stepped up basis of $500,000 and the sale value of $600,000. But note that that $100,000 is still substantially less than the $500,000 their taxes would be calculated from if they had to use your original basis.

Biden’s Stepped Up Basis Proposal

The two key components of Biden’s tax reform include raising the top end of the capital gains rate to 39.6% and nixing stepped up basis. The feds aim to take in more than $110 billion over 10 years with both proposals.

The capital gains hike alone could potentially cause revenue to decline in the near term, according to an analysis by the University of Pennsylvania’s Wharton School. That’s because investors would change their behavior and delay selling stocks.

That’s why the stepped up basis portion of Biden’s proposal is critical. We all pass away, eventually, at which point the U.S. Treasury taxes any capital gains from the sale of assets by estates and beneficiaries.

“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.

The bill includes an exemption of $1 million for individuals and $2 million for married couples, which is a dramatic increase from the exemptions offered by the Obama administration, which touted a similar proposal in 2015.

Eliminating Stepped Up Basis Could Raise Middle-Class Taxes

Despite this carveout, 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, who takes home $60,000 a year, making her an average American by earnings. 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.

Anne’s favorite uncle passes away, leaving her a beautiful beach house. The property was worth $300,000 when he bought it years ago, but now it’s valued at $1.8 million.

Under current law, Anne would inherit the property and the basis would be stepped up to $1.8 million. She could keep the house or immediately sell it without paying a dime in federal capital gains taxes.

Under Biden’s plan, the estate of Anne’s uncle would owe taxes on $500,000 worth of the property’s capital gains (what’s left after factoring the $300,000 basis and the $1 million exemption), which are now assessed at death. If the estate couldn’t come up with the funds to pay the bill, which would run about $100,000, they might be forced to sell the home.

In that case, it’s not exactly accurate to say that Anne’s taxes would not be impacted by the Biden administration’s proposed changes. That $100,000 bill looks a lot like a middle-class tax hike.

What Should You Do Now?

The hypothetical case outlined above would be exceedingly rare—most people don’t have rich uncles with million-dollar homes. And the new rule is designed to capture tax revenue from very well-off people who may not have enough wealth to be subject to the estate tax, which only kicks in on estates valued at $11.7 million or more. (Interestingly, the Biden administration hasn’t signaled it wants to lower that exemption.)

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.

That said, 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.”

For good measure, though, try to locate any documents and send them to your accountant for safekeeping, noted wealth manager Mallon FitzPatrick.

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. Or you may want to divy up chunks of assets to your heirs before you pass, assuming their income won’t exceed $1 million.

Stay Connected

Joseph Velkos, a Key Private Bank trust tax director in Cleveland, Ohio, 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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