In my Facebook group (Diane Kennedy’s US Tax Group), there are two key Biden tax points that are causing the most anxiety. We may lose step-up basis. We may lose the Section 1031 exchange for real estate.
This article is all about preparing, not panicking. So, don’t get too anxious. The fact is that a President doesn’t determine tax law in a vacuum. The House has to pass a new bill, which is then given to the Senate who has to approve it. And then, finally, the President can sign it.
With the current breakdown of the two Legislator houses, it’s unlikely that anything too controversial will get passed in the next two years. For that reason, I’m not sure we’ll see any big changes until 2023, and even then, I doubt we will have everything on the long laundry list of proposed Biden changes.
Let’s look at each of these two topics first and why they are an issue. Plus, of course, what IF they do end up being passed? What then?
What if we lose the step-up basis?
Step-up basis occurs when you inherit an asset. Currently, the basis on the inherited asset is determined to be the fair market value at date of death. (There is an alternative date you can use, but let’s keep it simple for now.)
Let’s assume your uncle bought a property for $100,000. You inherit it and it’s now worth $400,000. You decide to sell it and that’s what it sells for. No gain. Your basis has been stepped-up to the current value. But now let’s say that you don’t have step-up basis. You sell it for $400,000 and your basis is just $100,000. Your gain is $300,000 (assuming no expenses). That’s a BIG difference.
And that’s why a lot of people are concerned right now.
So, let’s step back now and look at what actions you could take. First of all, we would have a lot of notice before step-up basis is taken away. I’d bet it’s at least a year before we would see that in law and there could even be a phase-in of some kind.
An alternative plan that has been discussed quite a bit takes into account inflation. You wouldn’t have to pay tax on the value increase due to inflation. Let’s say your uncle bought the property in 1990 for $100,000 and he passed away in 2030. And we’ll assume the inflationary rate from 1990 – 2030 was the same as 1980 – 2020 (because that’s a known). The inflation rate in total is 235%. So, $100 in 1980 would be now be $335 in 2021. That means your Uncle’s house basis would be $335,000, when taking into account inflation. Your basis is $335,000 and a sales price of $400,000 (without any expenses) would mean a gain of $65,000.
There is still tax, but it’s a lot more palatable.
It’s hard to know exactly what will happen, of course, but this is the plan favored by most economists and think tank type people. That’s because it’s fair. The value didn’t change as much as inflation changed it.
Why losing step-up basis won’t work
We have another big issue to talk about that makes both of these plans pretty much impossible.
How do you know when exactly your uncle bought that house? How do you know how much he paid for it? (Remember he’s passed away and not around to ask) What improvements has he added to the house to increase the basis?
When you have old purchases like that it’s pretty much impossible to figure out what on earth the inherited basis would be.
Stock basis isn’t much better if the stocks were purchased prior to the electronic age.
When it comes down to it, most of this is going to end up being a wild guess because there simply won’t be records.
For that reason, I don’t think we’ll lose step-up basis. But let’s say we do. What then?
Last ditch if we DO lose step-up basis
Okay, but let’s say we DO lose the step-up basis for inherited property. What then?
The answer is “we’ll figure it out.” There are people just like me who read the new Tax Code as soon as it comes out.
No, scratch that.
We DEVOUR the Tax Code when it comes out. We read the Tax Court cases and all the opinions. We read the IRS rulings, instructions, procedural changes and Dept of Treasury pronouncements.
We figure this kind of stuff out for a living.
If you’ve followed me for any length of time, you know I’ve been around through a lot of big tax changes that were supposed to be “taxmageddon” and they weren’t as long as you were prepared to be flexible.
Right off the top of my head, I can think of 3 strategies to get around the loss of step-up basis. But there are two big caveats:
#1: You must be prepared to do something you hadn’t done before, and
#2: You need to have an advisor you trust who is paying attention to the changes and is even more proactive than you are.
What if we lose the like-kind exchange?
The like-kind exchange is also known as a Starker exchange or as a 1031 exchange.
This is used by real estate investors to sell a real estate investment and then “roll” the proceeds over to another real estate investment. You defer the taxes until you later sell that property. There are a lot more rules and strategies with this, but that’s the basics.
There is talk about getting rid of the like-kind exchange.
In actuality, the like-kind exchange isn’t a tax avoidance strategy. It’s a tax deferral strategy. You’re getting rid of a property you don’t want but you are getting another one in its place.
This is heavily lobbied by the real estate groups, including the National Realtors Association. I honestly doubt we’ll lose this, but let’s say we did.
What would we lose? In fact, we may see people going to other strategies that defer the payments with installment sale treatment or eliminate it completely with a charitable remainder trust.
Losing the like-kind exchange would actually be freeing for some of my clients. Instead of looking for another real estate investment in a short period of time with narrow parameters of what they can spend, how they buy it and how they handle the proceeds, they can be more creative in the next purchases.
There is no discussion about losing the homeowner’s capital gain exclusion which, in my opinion, would be a lot tougher to overcome.
Two changes we should be watching
There are a lot of changes that MAY occur with a Biden presidency. Here are two that you may want to start preparing for:
.Payroll tax for W-2 income over $400K, and
.Limiting itemized deductions to 28% of adjusted gross income.
#1: If you are a high-income earner from W-2 wages only, guess what. You’re going to get screwed again. Higher taxes ALWAYS hit employees. Occasionally, they impact business owners and real estate investors but there are always alternatives ways to get the same results.
Employees don’t have options unless they start a business or invest in real estate. And, you have to be prepared to plan ahead and be flexible. Otherwise, you’re getting more taxes.
#2: The limit on itemized deductions means that people who are relying on high mortgage interest, medical expenses and charitable donations to reduce their taxable income are screwed.
What do you do about that? Start a business.
Use part of your home for a home office and pick-up deductions.
With the right business structure, you can write off your medical expenses.
Although I think there will be an exception made for charitable donations, you can still find strategies to take advantage of those through your business, too.
How do you prepare for more payroll tax and the loss of your itemized deductions?
Start a business.
What about the proposed C Corp increase to 28%?
I’m convinced by Sec of Treasurer Yellen’s statements on this that they won’t rush into increasing the C Corp flat rate tax. That’s because most corporations operate on the world stage. If the US’s corporate tax rate become higher than other industrialized nation’s, companies will flee.
She stated that it would have to be done in cooperation with other nations. I agree that’s the only way it will happen. And I also believe that if it happens, it’s not happening any time soon.
For that reason, this is a “don’t care” for me. I still recommend C Corps and if nothing else, you can save a whole lot of money now and change it later if there is a tax law change.
Of course, you need a business and it has to be the right structure for your particular circumstances.
The Bottom Line
To sum it all up, prepare for changes. Don’t panic. There are plenty of options and strategies.
If you don’t have a business, start one. It could be a part-time business, a side business, a hobby that you’ve taken to a whole new level. Just start a business.
The most important part of all of this is planning ahead, building a knowledgeable team and being flexible enough to act quickly and decisively.
That’s how you win during times in flux like this.