Here We Go Again: Proposed Tax Laws and What to Do About Them
August 18, 2021
Tax law is one of those exciting topics that never goes out of style, am I right? As of the writing of this blog, there’s a lot of discussion about recent proposals from the Biden administration. With this buzz about increased tax rates and many people wondering how these changes might affect their overall financial situation, we wanted to provide some insight about how these proposals could affect your plan.
A Few Things to Keep in Mind About the Proposed Tax Legislation
The all-encompassing issue that has most people talking is, of course, paying higher taxes. After all, nobody loves giving up money to Uncle Sam, and everyone wants to know if and how these new laws might affect their future. In general, lower tax rates enacted by the Trump administration are now being overturned or altered, and some are worried about an increase in capital gains taxes or changes to estate tax law that would require heirs to pay taxes they’ve previously been exempt from.
While these are valid concerns, the important thing to remember about these proposals is just that—they’re proposed changes; they’re not written in stone yet. As with most political agendas, it’s possible (and even likely) that proposed legislation either won’t pass, or it’ll be implemented in a much milder way.
Another thing to note is that many of these proposals only affect the top 1-5% of earners. If you don’t make more than $500k a year (or $1 million for married couples filing jointly), a lot of these new laws likely won’t affect you (keep reading to learn more about the exceptions).
That said, it’s still important to prepare for the more extreme scenarios, especially since some of these proposals might put you in a different income bracket. Below, we’ll cover a couple of recent tax proposals, whom they affect and how, and what you can do to prepare for them.
Before we dive into the proposals, here are a few terms you’ll need to know:
- Asset: anything of value an individual or couple owns
- Estate: the sum of a person’s total assets, minus their liabilities (e.g., a person’s home value + stocks + valuables – debt = total estate value)
- Basis: for tax and legal purposes, a “basis” represents the taxable value of an asset
- Appreciated Value: the increased value of a property, stock, or other asset (e.g., when you purchase a home for $100,000 and 15 years later it’s worth $200,000, that’s the home’s appreciated value)
Proposal #1: An Increased Capital Gains Rate
What it Means
Currently, the capital gains tax rate for individuals earning more than $500,000 per year (or $1 million for married couples filing jointly) is 20 percent. Under the proposed increased rate, these same earners would pay 43.4 percent in capital gains. Obviously, that’s a big jump—more than double the tax rate for capital gains. If this new law goes into effect, individuals could end up paying a much higher capital gains tax on appreciated stocks they sell, liquidation of a business, or money inherited at the transfer of an estate.
Who it Affects
- Individuals earning more than $500k per year
- Married couples filing jointly who earn more than $1 million per year
- Business owners (Even if you earn less than $500k per year, selling your business for $1 million or more could place you in this higher tax bracket.)
- Land and property owners (As with business owners, if sell your property for, say, $10 million, you could be subject to paying $4.4 million in federal taxes, rather than the $2.3 million you would pay under the current rate.)
Proposal #2: Decreased Estate Tax Exemptions
What it Means
Currently, individuals with estates valued at $11.7 million ($23.4 million for married couples) or less don’t pay the 40 percent estate tax (which is due at the time of death). As such, estate taxes haven’t been much of a concern for most people, given that only a small percentage of couples have estates valued at more than $23.4 million. However, under the proposed reduced exemption rate, individuals with estates valued at just $3.5 million or more ($7 million for married couples) would have to pay the 40 percent tax on the value of their estate that exceeds $3.5 million—so a couple with a $12 million estate would pay taxes on $5 million.
Along with this lower exemption rate, officials are considering increasing the estate tax from 40 percent to 45 percent—meaning individuals who previously didn’t have to worry about paying estate taxes at all (say, a couple with a $10 million estate) would have to pay more than $1.3 million in estate taxes under the proposed new rate.
Overall, this proposal means that most high-net-worth individuals (and even some who don’t consider themselves as such) would have to start paying estate taxes they were previously exempt from, or pay them at an increased rate.
Who it Affects
- Individuals with an estate valued at more than $3.5 million (If you consider individuals who might have a highly appreciated home and stocks—yet aren’t high-earning—this new tax law could greatly impact individual financial outcomes.)
- Married couples with an estate valued at more than $7 million
Proposal #3: Loss of the “Step-Up in Cost Basis”
What it Means
First, let’s define a step-up in cost basis—after a beneficiary inherits an asset that has appreciated in value (like a home), a step-up in cost basis is an adjustment to the asset’s taxable value (the basis). This step-up provides tax advantages for individuals inheriting assets with significant value.
For example, let’s say Mark purchased a home for $50,000 that has appreciated to $1 million at the time he wills it to his son, Brett. With a step-up in cost basis, Brett doesn’t have to pay the capital gains taxes on the gains his father earned. Instead, his tax value is “stepped up” to the new $1 million value. If Brett decides to sell right away, he won’t incur any capital gains taxes.
If Brett owns the home for more than a year and sells it for $1.3 million, the step-up in cost basis means he only pays a capital gains tax on the difference between the inherited tax basis and the sale price ($300,000). But without this step-up in basis, Brett would have to pay taxes on the difference between the original purchase price ($50k) and his sale price ($1.3 million)—so he would pay capital gains taxes on $1.25 million.
This step-up strategy is one that’s been in effect since 1921, and, clearly, it provides some advantages for individuals inheriting significant assets. The same rule currently applies to appreciated stocks, so shareholders often hold appreciated stock until death, allowing their beneficiaries to sell after a step-up—rather than sell them themselves and pay the capital gains tax.
Now that we understand the current tax advantages, that brings us to our next proposal—legislators are currently seeking to eliminate this step-up in basis altogether. Using the example above, that would mean that even if Brett sold his father’s home immediately after he inherited it, he’d have to pay the gains on the $950k appreciation from the time his father bought the home for $50k and a sale price of $1 million. If this proposal is passed alongside the new capital gains tax rate (43.4 percent), Brett would be paying nearly $418,000 in capital gains taxes on the sale of his father’s home—not including state taxes. Obviously, that makes inheriting a $1 million home a little less exciting.
Who it Affects
- Individuals inheriting more than $1 million in appreciated assets (So—using the example above—if Mark had only $500,000 of appreciated assets and his son Brett decided to sell everything upon his death, Brett wouldn’t incur any capital gains taxes, even under the new proposed law.)
That said, when it comes to your estate plan, you should consider the combined appreciated value of all your assets (not just property). If you have a highly appreciated home and stocks that are also highly appreciated, you might have already surpassed that $1 million mark.
What You Can Do to Prepare for These Proposed Changes
For individuals affected by these proposed changes, one of the most effective strategies you can implement is to purchase a permanent insurance plan—these policies can provide a death benefit that may offset your estate taxes.
You can also focus on gifting strategies now that would decrease the total value of your estate. That said, there is another proposed legislation which would reduce the $11.7 million gift exemption to $1 million per person—meaning you could only gift $1 million to each of your heirs before they would be required to pay a 45 percent gift tax. But again, that’s if that proposal is passed.
If you’re concerned about the proposed changes, the best thing you can do is talk to your team of professionals, like your financial advisor, your estate attorney, and your CPA. Even if some of these laws don’t apply to you in the present, we can review your projections to see if you’d be in a higher tax bracket in the future, should some of these laws be enacted. Then, you would at least be aware of possible tax implications and be able to consider strategies that could offset future losses.
One Last Note
Above all, don’t worry. It sounds like a cliché, but that’s why we’re here. None of these proposed laws are finalized yet, and the details could change at any moment. Even if they are put in place, there’s nothing to stop the next administration from reversing or altering them later (such is the cycle of American politics). So while we want you to be aware of potential changes to your financial strategy, you probably don’t need to overhaul your entire estate plan just yet. If you think that you might need to make some adjustments, we’re happy to review your strategies with you and your other financial professionals to ensure you stay ahead of the game.
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We do not provide tax or legal advice. Please consult your tax professionals and attorney for advice about your unique situation.