President Biden has proposed a lot of changes to our current tax system. The most commonly discussed include:
Increase the C Corp tax rate from 21% to 28%
Global minimum tax of 21%
Top income tax rate increase to 39.6%
Capital gains tax increase
Loss of step-up basis
The latter one, losing the step-up basis, is what we’ll talk about in today’s article.
Let’s start with looking at a real life case under current law and then what would happen under the proposed law change.
Stella is a Boomer who inherited rental property from her hard working father. He was a handyman by trade and his skills had come in handy as he picked up rundown single-family homes. He repaired them and rented them, doing all the property management himself.
He wasn’t a big spender, except when it came to buying real estate.
When he passed away, he had a portfolio of 20 single family homes, worth approximately $3,000,000 in today’s market. He also left Stella, his only heir, his home which was worth about $200,000.
Stella decided to sell two of the properties right away. They were in a sketchier part of town and weren’t always easy to rent. They probably would sell for about $120,000 each.
She worried about how much tax she’d need to pay on the sale.
“Nothing,” I assured her. “You just inherited the properties so the step-up basis, or fair market value, is going to be the same as the sale price.”
“So I never have to pay tax on these properties?” she asked, brightening considerably.
“Not exactly. If you have net income from the rent of the properties, that will be taxable. If the property is worth $150,000 now and you sell it in 5 years for $250,000 then you’ll have gain to pay tax on,” I explained. “But for now, there is no tax if you sell.”
What is Step-Up Basis?
Current tax law (before any Biden tax changes) allows for something called step-up or stepped-up basis. This means that the assets you inherit are valued at their current value. It doesn’t matter what the basis was before. They now are worth the fair market value. Step-up basis minimizes your tax bill when you sell. It also increases the basis so you can take more depreciation if you want to.
Proposed Estate Tax Changes
There are several possible changes to estate tax that have been proposed. These include:
Changing the estate tax exemption from $11.7 million to $3 million. That means if the estate is valued at over $3 million, there will be an estate tax.
UPDATE: It looks like this will not happen. The estate tax exemption will stay at the current $11.7 million value.
Creating a tax on the estate immediately. Unlike losing the step-up basis which creates a tax when you sell the asset, a tax on inheritance, would mean there would be a tax right away.
This is probably the hardest of all taxes for the heirs. They have to pay tax even though the assets they get might be illiquid and hard to convert to the immediate cash needed. That’s basically what happens when the estate exemption is dropped. This plan would make it even worse.
UPDATE: This also seems to be dead on arrival. Although some more progressive Democrats have called for this tax, it doesn’t have a lot of support.
Losing the step-up basis.
UPDATE: This plan to eliminate stepped-up basis still has traction, but there are a few serious issues.
#1: You would inherit at the deceased party’s basis. Most people have a hard enough time keeping track of their own basis in assets. How on earth can they determine what the basis is for assets they didn’t own?
Some assets may be easier to track, such as stocks that have been managed by an investment firm. But determining the basis of personal assets such as a home would be hard to do.
#2: Small business basis would be pretty much impossible to determine unless the business was held in a business entity such as a Corporation. Otherwise, there is no requirement to report basis by small business owners. Most don’t.
Stella’s Inheritance If There Was No Step-Up Basis
Let’s assume the same situation for Stella except this time there is no step-up basis. She makes the same decision. She’s going to sell the two low performing real estate properties.
To calculate the gain she’d have, she would need to know the accumulated depreciation and the basis for the properties. Most likely the depreciation schedule and worksheets that her uncle’s accountant had prepared would have that information.
When she sells, it would have the same tax impact as if her uncle had sold it. She’d have to calculate the gain and recapture the depreciation.
We’ll assume that the two properties sell for a combined price of $240,000. There is a cost of sales of $20,000 and the basis for the properties were $100,000 (combined) with accumulated depreciation of $50,000
The gain is calculated as:
Sales price: $240,000
Less: cost of sales ( 20,000)
Less: Basis (100,000)
Plus: Depreciation 50,000
Gain: $170,000. Of that, $50,000 is taxed at the higher depreciation recapture rate. The rest ($120,000 or $170,000 – $50,000) would be taxed as the capital gains rate.
Assuming an average, middle class income for Stella and her husband, they probably are looking at a tax of about $25,000.
But Stella has another thing she wants to do.
She wants to sell her uncle’s house too. That’s more complicated.
It’s a house that he bought years ago and she doesn’t know how much he paid or how much the improvements were that he’d done over the years.
And at this point, there is no easy way to figure out the gain that she might have. From what we know of the possible law would be, it’s going to take your best guess of what the basis would be. Of course, if you’re audited, it might be hard to prove that.
For that reason alone, I don’t think that we’ll lose the step-up basis without some additional information on HOW to calculate from the IRS. We just don’t know what we don’t know.
What Kind of Strategies Can You Use If You DO Lose the Step-Up Basis?
Until we know exactly how the change will work, we can’t determine what strategies will be effective. Here are some thoughts on what might work:
Move into an inherited single residence for 2 years and use the 2 out of 5 year capital gain exclusion.
Donate appreciated stock prior to sale. You could combine that with the high income/charity strategy to fund a charity that eventually employs you. (This is just one of the many proprietary strategies that we use for our clients.)
Donate appreciated assets to a charitable remainder trust. In the right circumstances, this can give you a big charitable donation, cash flow and no tax on the sale.
Move assets into a Roth IRA or Roth 401(k).
Gift assets if you’re concerned about hitting the estate tax limitation.
That’s just off the top of my head while I’m writing today’s blog. The fact is that whatever tax changes come up, there will be people like me who find ways for our clients to pay less tax.
It all comes down to just a few steps for you:
Know what you want and where you are,
Hire experienced tax strategists, and
Free Advice Can Be the Most Expensive Advice You’ll Ever Get
I see people posting technical questions on Facebook all the time, looking for free answers. And I shudder at some of the responses.
Not only are the commentors wrong, but often they’ll end up costing you even more money than if you did nothing. You may see a qualified accountant or tax attorney responding for tax questions, but the responses will be general. And it’s hard to sort out the few good answers from all the rubbish.
And even if the advice you get is valid, it’s hard to say whether it will be the best answer for you.
Our Wednesday Coaching goes through strategies designed to put more money in your pocket, reduce your taxes and build your wealth. Plus, you can review your own personal tax situation with me, live.