The Stepped-Up Basis May Be Getting Stepped On

The Stepped-Up Basis May Be Getting Stepped On

May 05, 2021

The Biden administration recently released a $1.8 trillion infrastructure package that detailed the proposed spending and, more importantly, laid out potential avenues to pay for it. One of these is eliminating the ability to pass stocks, real estate, and other capital assets onto heirs without 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 across the wealth spectrum, not just for the ultra-wealthy. A change in the law could necessitate some re-jiggering of estates to attempt to protect assets as much as possible from estate taxes.

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

What Is the Stepped-Up Basis?

Let’s assume your favorite aunt has been holding a stock she bought thirty years ago for $5,000, and it has increased in value to $50,000. If your aunt sells the stock, she will have a capital gain.  She calculates her capital gain 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.

Now let’s say you inherit the stock from her and decide to cash out right away. Current tax laws allow for the basis to “step up” when you inherit it. In other words, for most people, your basis becomes the value of the stock when you inherited it.  Large estates may select an alternate valuation date which is 6 months later.  If you sold immediately and there was no change in price, there is no tax due. If you held onto the stock and it appreciated further and then 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 Step-Up – the Details

The proposals for eliminating the step-up in basis are in the early stages, so details aren’t complete. Basically, though, it calls for the elimination of the stepped-up basis for gains of $1 million or more ($2 million or more for a married couple).

There may be more exceptions in addition to those for gains of less than $1 million. Gifts of appreciated property passing directly to charity will continue to avoid capital gain taxation. Family-owned businesses in which the heirs continue to run the business may 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 for married couples), and this would stay in place. There may be other exceptions as details become more explicit.

That’s Not the Only Proposed Change

It is transparent taxation to capital gains is under fire.  In addition to eliminating the step-up in basis, there is a separate proposal 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 (depending on the estate size). 

According to a study by the University of Pennsylvania’s Wharton School, eliminating the step-up in basis 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.

Will the Changes Likely Pass?

They seem to be a pretty tough sell, especially as both proposals have to pass for them to be tax-revenue positive. While the Democrats do have control over both the House and Senate, the majority is razor-thin.  Some Democrats have already expressed concern over the proposals. 

However, if you’re worried about your estate plan, it’s a good time to look things over and discuss what strategies can potentially safeguard your plan ahead of any changes. If you need help considering what techniques to consider for your situation, you can reach out to us at info@rivercitywealth.com; we are happy to help.

This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation. Advisory Services Network, LLC does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state laws are complex and constantly changing. You should always consult your own legal or tax professional for information concerning your individual situation.