A Hui Hou (Bye, Bye), Stepped Up Basis.

The Biden administration recently released a $1.8 trillion infrastructure and social support package for the lower and middle class wherein they detailed how the funds would be spent. Along with the proposal, they laid out ways the plan to pay for it. One of the avenues they intend to go down is eliminating the ability to pass stocks, real estate, and other capital assets on to heirs without those folks paying capital gains tax.

The Biden proposal would eliminate the “stepped up basis,” which makes the avoidance of capital gains taxes possible and is currently a big part of estate planning. A change in the law would necessitate in depth reviews of estates in order to attempt to protect appreciated assets as much as possible from estate taxes.

It is of course too early to know if this will become part of the final package, but it’s never too early to understand the problem and start thinking about potential solutions.

What Is Stepped-Up Basis?

Let’s assume your favorite aunt has been holding a stock she bought thirty years ago for $5,000. You inherit the stock from her, and it has increased in value to $50,000. You decide to cash out right away. The capital gain for tax purposes would be determined by subtracting the basis (typically the amount paid for the stock) from the value of the stock at the sale price. In this case, $50,000 – $5,000, or $45,000.

However, current tax law allows for the basis to “step up” when you inherit it. In other words, your basis becomes the value of the stock when you inherited it. Since you sold immediately and there was no change in price, there is no tax due. If you held onto the stock for some period of time and it appreciated further and then you sold it, your capital gain would be the difference between your basis ($45,000) and the stock’s appreciated price when you sold it.

Eliminating the Basis – the Details

The details aren’t completely clear, but what we do know is that it calls for the stepped-up basis to be ended for gains of $1 million or more ($2 million or more for a married couple).

There are more exceptions, other than those for gains of less than $1 million. If the property or asset that would be subject to capital gains taxes is donated to charity, it would not be taxed. Family-owned businesses in which the heirs continue to run the business would also be exempt, and the same goes for family farms.

Primary residences that are transferred to heirs currently have an existing capital gain exclusion of up to $250,000 ($500,000) and this would stay in place. There may be other exceptions as details become clearer.

That’s Not the Only Proposed Change

The plan also proposes to raise the top tax rate on long-term capital gains to 39.6% from 20%. The change would only apply to people earning $1 million and above. Short-term gains don’t escape notice either – they are currently taxed at the ordinary income rate – but the plan also proposes to raise that rate to 39.6%, in essence eliminating the difference between short-term and long-term gains.

The two changes are coupled together because current law allows investors to avoid taxes on unrealized capital gains. If the assets were held until death and passed through an estate, the heirs would receive them at current market value and the estate would avoid the taxes.

A recent study by the University of Pennsylvania’s Wharton School found that if the step up in basis was eliminated, the change would generate $113 billion in tax revenue over a decade. However, if the step up remained in place, the proposed changes to capital gains tax rates would actually cost $33 billion in tax revenue over a decade as investors enact avoidance strategies.

Conclusion

Will the changes likely pass? Well, they seem to be a pretty tough sell, especially as both proposals have to pass for them to be tax-revenue positive. However, if you’re worried about your estate plan, it’s a good time to look things over and have a conversation about what strategies can potentially safeguard your plan.

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