TAXES ESTATE ADV14

Under current rules, the federal estate tax won’t ever affect you unless you’re quite wealthy. But that could change rapidly, even if you are far from rich.

Proposals under consideration by President Joe Biden could extend the tax to millions of people. That could happen in two ways: by raising rates and lowering qualifying thresholds on estates, and by increasing the liability of people who inherit and sell any assets.

Together, these changes could raise money from the truly wealthy while also imposing a levy on vast numbers of people who inherit assets like a modest family home.

Inheritance taxes are paid by the estate of a person who has died. While many states have estate taxes with lower asset thresholds, right now, a married couple would need an estate of more than $23 million to even start worrying about federal taxes on it.

But as a candidate, Biden spoke about several possible changes to the estate tax that could affect far more people, and in the process, raise tax revenue. One of those changes would end a tax shelter that many people have taken for granted.

Known as the “step-up in basis at death,” this provision erases all of the capital gains in a deceased person’s portfolio and values everything at the date of death. If the step-up in basis were eliminated, inheritors would have to pay capital gains whenever they sold the assets, including millions of dollars worth of stocks or a family home.

Janet Yellen, the Treasury secretary, said in an interview with The New York Times last month that she intends to examine the implications of ending the step-up provision.

For people lucky enough to inherit wealth, this nugget in the tax code has been something of an accounting gift from the gods. Someone who inherits stock doesn’t need to worry about things like what mom or dad paid for shares of IBM years ago. That’s because all the capital gains in those shares — and any other inherited investment — are effectively wiped out when the benefactors die. Whatever the assets are worth at death is what family members inherit. There are no pesky capital gains to calculate — or taxes to pay.

What’s gained by heirs, though, is lost by tax collectors and the public at large. Had the recently deceased sold those shares — or, say, an apartment building — during their lifetime, capital gains taxes would have been incurred. As the law now stands, though, those capital gains are extinguished at death.

Elimination of the step-up rules could capture billions in taxes from the rich but hurt some people who do not have enormous wealth. Consider a hypothetical couple who bought their home 40 years ago for, say, $75,000, paid the mortgage, maintained the yard, made some upgrades and now find themselves with a house worth $300,000 or more. For many families, a house like that forms the basis of a modest estate to pass to heirs. Now, if heirs ever sell that house, they will be responsible only for gains above $300,000; if the step-up in basis were eliminated, they would owe taxes on any amount above the original $75,000.

The loss of a step-up in basis at death would change the calculus for real estate and any other highly appreciated asset. (Think of Apple stock bought in the 1980s, or Bitcoin from 10 years ago.)

“Most of America has their wealth concentrated in their home,” said Chris Bixby, senior wealth adviser at Mariner Wealth Advisors. “That would be subject to the step-up. I’m talking to people about gifting the house earlier to get it into their heir’s name, so the appreciation happens in their name, not yours.”

That may be a step too far for many people, who will want to retain ownership of their home.

There is also a broader equity issue.

Elimination of the step-up in basis could make it harder to bridge the racial wealth gap, said Calvin Williams Jr., CEO and founder of Freeman Capital, a wealth management firm. He noted that the Brookings Institution has found that Black families, on average, have about one-tenth the wealth of white families — $17,150 versus $171,000. In addition, Brookings estimates that only 10% of Black families inherit any money, about $100,000 on average, compared with about 30% of white families, who receive about $200,000.

Elimination of the step-up rule would make it more difficult for Black families to pass on whatever wealth they have been able to accumulate, he said.

“The fact that the inheritance gap has continued to grow, even as Black income is continuing to grow, shows just how much work needs to be done to close that gap,” he said.

It might be more equitable to create a cap on the step-up in basis that would exempt people below a certain amount of wealth, he said: A $500,000 exemption would provide relief to many middle-class families. This would be similar in spirit to another proposal under consideration by the Biden administration, an increase in capital gains taxes for people earning more than $1 million a year.

Another proposal, reducing the estate tax exemption, could induce modestly wealthy people to make estate plans they haven’t needed in years.

Twenty years ago, the estate tax exemption was $675,000 a person and the tax rate was 55%. But the exemption grew and the rate fell over the next two decades. When President Barack Obama took office in 2009, the exemption was $3.5 million, with a 45% tax above that amount. It’s now $11.7 million a person, with a 40% tax above that amount.

Biden has discussed lowering that exemption, perhaps back to the 2009 level. That would capture more estates and increase tax revenue.

“There were 4,100 estate tax returns in 2020 and 1,900 were taxable,” said Joseph Velkos, trust tax director at Key Private Bank in Cleveland. In 2009, when the exemption was one-third of what it is today, he said, “there were 12,900 returns, and 5,700 were taxable.”

Some wealthy people may want to use their current estate tax exemption to make gifts now, before that loophole shrinks: Under current rules, you are permitted to give away up to $11.7 million, which is counted against your total estate when you die. But if the rules were to change and you gave $5 million today, and the permitted exemption level dropped from $11.7 million to $3.5 million next year, you could no longer make tax-free gifts.

That’s the way changes in the tax code have traditionally worked, said Amanda DiChello, shareholder at the law firm Cozen O’Connor.

“There’s no carry-over that would have been left as a result of a prior administration or prior tax code,” she said. “The only thing that is portable is if you had a spouse who died when the exemption was higher.”

In that case, the surviving spouse, with some planning, would get to tack on the current exemption level as if they were still married.

Much of this is speculative, of course. Hanging over any long-term tax planning decisions are perennial questions: Will the current administration enact these changes, and if the answer is yes, will they last into future administrations?

“If we look at the last number of administrations, all the tax bills they’ve passed have been temporary,” Bixby said. “We shouldn’t make long-term decisions based on something that will likely change in the future. We need to make the right long-term decision, not one guided by taxes.”

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