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Proposed Changes Could Mean New Capital-Gains Taxes at Death

Benjamin Franklin said that nothing is certain in this world except death and taxes. But some uncertainty around the latter has caused some Americans to call their attorneys with questions on what the changes would mean for them.

A proposed change by the Biden administration in how estate tax – also known as inheritance tax – is calculated could have huge implications on how much a beneficiary would inherit. There is no surefire way to predict whether these proposals will come to fruition but understanding these potential changes and how they could impact you is important.

Let’s first take a broad look at President Biden’s plan and tax implications.

Reported Purpose in Changing the Tax Laws

Three key features of Biden’s Build Back Better program would be funded by tax changes.

  • American Rescue Plan. Of the three components we will discuss, this is the only one that has been enacted. The plan provided cash payments to individuals and changed individual tax laws that benefited lower-income individuals and families, such as increasing the child tax credit for 2021. Most of these tax changes are temporary and intended to support those impacted most by the pandemic.
  • American Jobs Plan. This infrastructure plan would increase the taxes paid by corporations on their profits. It calls for a higher corporate tax rate and minimum taxes on the profits of multinational corporations.
  • American Families Plan. This plan would establish new family and education programs. American children would receive two years of free prekindergarten for 3- and 4-year-olds as well as two years of free community college. Other features include paid family and medical leave and expanded childcare. Helping to pay for those programs are higher taxes on wealthy individuals, notably a higher capital-gains rate.

This blog will focus on the capital-gains tax changes related to inheritance.

Step-Up Vs. Carryover Basis

The current rules follow a step-up basis upon death: If a person owns an asset that has appreciated, the asset's market value at the time of inheritance is the basis for capital gains when that asset is sold, not the initial purchase price.

Biden’s proposal changes the rules to carryover: With that same asset described above, the basis for capital gains is based on the initial purchase price.

To provide a concrete example, let’s say you inherit a home from an aunt. She purchased the house for $200,000, but its fair market value at her death is $550,000 and you sell the property for $565,000. With step-up basis, your capital gains is based on $15,000 – the amount over the current fair market value you received. If you do not sell it, you pay nothing in federal capital-gains taxes. You would only pay when you sell and only on gains since your aunt’s death.

With carryover, if you sold the house like the previous example, you are liable for gains of $365,000 – the amount over your aunt’s initial $200,000 investment. The other big change under this proposal is that you would owe capital gains even if you do not sell. You would be paying taxes on $350,000, the amount over the original investment, that the house is worth when you inherit it. The proposed tax rate is almost 40%.

Exceptions to the Proposed Carryover Rule

  • If you inherit a family business, you only pay capital gains taxes when you sell it.
  • Inheritance to a surviving spouse is not taxed – until they sell the asset or upon death.
  • Gifts to qualified 501(c)3 organizations are exempt from any estate tax. There is no limit on the amount that you can donate to charity.
  • Personal property, like household furnishings and personal effects, but excluding collectibles, is exempt.
  • Gains on a primary residence of up to $250,000 ($500,000 for a married couple) is exempt.
  • The first $1 million ($2 million for joint income tax filers) of unrealized gains – you have not sold the assets – would be exempt from the new tax.

The proposal does provide a 15-year fixed-rate payment plan for assets, not including liquid assets.

The discussion here is just about federal taxes. Some states also levy these taxes, but Wisconsin does not assess inheritance or estate taxes. You could owe an inheritance tax in another state if you inherit money or another asset from someone who lived in a state that does assess the tax.

In addition to the capital gains, a federal estate tax is in play as well. Currently, the estate tax is only assessed on estates over $11.7 million ($23.4 million for a married couple). Biden’s proposal could reduce that threshold to $5.3 million ($10.6 million for a married couple).

Changes to Trusts

A popular vehicle wealthier Americans use to avoid incurring gift or estate taxes while providing for future generations is something called dynasty trusts, also referred to as legacy trusts. Wisconsin is one of a handful of states that places a limit on these types of trusts. The trust must end 21 years after the death of the last known beneficiary.

Biden’s proposal seeks to force trusts to pay capital-gains tax on appreciated assets every 90 years, regardless of whether a beneficiary is still living. The proposal’s language would impose taxes as early as Dec. 31, 2030. As of now, there is no change to the exempted $15,000 annual gift per recipient.

We are focusing here on issues around inheritance, but the proposed tax changes in the American Families Plan also affects the living, including:

  • The top marginal income tax rate would rise from 37% to 39.6%.
  • The value of 1031(b) exchanges would be capped at $500,000 (allowing real estate investors to roll gains from the sale of buildings into new buildings without ever paying capital gains taxes).
  • The Child Tax Credit (CTC) would be extended through 2025 ($3,600 for children under age 6 and $3,000 for children ages 6 to 17) with phaseouts for higher-income households.
  • The Child and Dependent Care Tax Credit (CDCTC) would become permanent (covers up to 50% of qualifying childcare expenses up to $4,000 for one child and $8,000 for two or more children).
  • Long-term capital gains and dividends would be taxed as ordinary income for taxpayers with taxable income above $1 million.

Suggestions for Estate Planning

This is a time to prepare for the potential scenarios. No one can predict what final form the proposal will take and whether a bill will even make it from Congress to the President’s desk for signature. Tax code is always complicated and affects everyone differently, depending on their financial situation. Whatever changes occur will be no different.

You will want to talk to one of our attorneys to determine steps you can take for your estate plan, but you can consider:

  • Making gifts this year before some changes would take effect.
  • Avoiding the potential higher marginal income tax by collecting income before the increase, if you have the ability to choose when you collect income. This is sometimes called tax-gain harvesting.
  • Purchasing insurance to pay the capital gain taxes.
  • Passing along assets that remain close in value to their purchase price, reducing the tax liability of your heirs.

As the tax code landscape continues to shift, your best offense is a good defense. If you have not established a relationship with an attorney who has estate-planning experience, now is the time to begin. If you have an established estate plan, this is also the time to talk to an adviser about making possible changes.

At Kitzke & Canfield LLC, our lawyers have an extensive understanding of both the current law and the proposed changes. When you are our client, you can trust we have our eyes on the national and local levels for any changes that could impact your bottom line.

Contact us today to schedule a consultation for estate planning at (262) 214-6827 or use our online form.

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