While the outcome of the upcoming election is impossible to predict, a Democratic sweep would likely lead to a radical shift in the tax landscape. Some estate planning strategies that are currently available may be eliminated and, while tax reform legislation is unlikely to be enacted right away, it is possible that when legislation does pass it could be applied retroactively to January 1, 2021. It is therefore important to understand what changes may be on the horizon and, for those who may be affected, the time to start planning is now.
In general, tax increases will target “high net worth individuals”, defined as those earning more than $400,000. It is not clear at this point whether the $400,000 threshold would apply equally to singles, heads of households, and/or married joint-filing couples. A brief summary of some of the key expected changes is set out below.
Increased personal income tax rates on the wealthy
in 2018 Trump’s Tax Cuts & Jobs Act (TCJA) reduced the top federal income tax rates on individuals from 39.6% to 37%. Biden’s tax plan would put the top income tax rate back to 39.6% on personal income in excess of $400,000.
Higher maximum tax rate for capital gains
one of the most dramatic changes proposed under Biden’s tax plan involves the way capital gains are taxed. In particular, for long term capital gains (assets held longer than one year), the tax rate on gains currently maxes out at 20%, with anyone earning less than $441,450 paying 15%. The Biden plan, however, would create an entirely new tax bracket just for long-term capital gains in which gains for individuals with incomes higher than $1 million would be taxed at 39.6%. That is a very significant increase.
Increased estate and gift tax exposure
when it comes to estate planning, the most critical aspect of Biden’s proposed tax increases would be a major reduction in the federal gift and estate tax exemption. Starting in 2018, the TCJA doubled the gift and estate tax exemption from prior levels, increasing to $11.58 million for single taxpayers and $23.16 million for married couples. Any amounts above this exemption you give away during your lifetime or transfer upon your death are subject to a flat 40% tax.
The increased exemption amounts under the TCJA will sunset at the end of 2025, but if Biden wins the presidency, the enhanced exemption could be repealed much sooner. Indeed, Biden proposes to reduce the exemption back to at least the 2017 level of $5.45 million for individuals and $11.58 for couples.
There are others who suggest the federal gift and estate tax under Biden might even return to 2009 levels, when the individual exemption was set at $3.5 million and the estate tax rate was 45%. What’s more, seeing that in the past lawmakers have made estate tax rates retroactive, it’s possible that these changes could be applied retroactively and go into effect as early as Jan. 1, 2021.
Whatever the final outcome, it’s clear that if you have assets valued between $3.5 and $11 million, you should seriously consider taking steps now to take advantage of favorable estate-tax exemption rates that may soon no longer be available. To this end, you should consider opportunities to transfer assets out of your estate now in order to lock in the higher exemption amounts.
Elimination of step-up in basis on inherited assets
In addition to raising the capital-gains tax rate, Biden has also proposed repealing the step-up in basis on inherited assets. Under the current step-up in basis rule, if you sell an inherited asset that has appreciated in value, such as real estate or stock, the capital gains tax you owe on the sale is pegged to the value of the asset at the time you inherited it, rather than the value of the asset when it was originally purchased.
This can minimize, or even totally eliminate, the capital gains you would owe on the sale. For example, say your mother originally bought her house for $100,000. Over the years, the house grows in value, and it’s worth $500,000 upon her death. If you inherit the house, the step-up would put your tax basis for the house at $500,000, so if you immediately sold the house for $500,000, you would pay zero in capital-gains.
However, if the step-up in basis is repealed and you sell the house, you would owe capital gains tax based on the difference between the home’s original purchase price of $100,000 and the price at which you sell it. And whether you sell it right away or wait for it to increase in value, you’d be on the hook to pay exponentially more in capital gains, compared to what you’d owe with step-up in basis in effect.
At this point, it isn’t clear exactly how the new rules would work under Biden’s plan, or what, if any, exceptions would apply. That said, if step-up in basis is repealed, your loved ones most likely won’t be able to avoid paying capital gains on appreciated assets they inherit from you.
It is never too early to plan. Strategies take time to devise and implement. We are happy to discuss options with anyone who may be affected by the radically different tax landscape that may (or may not!) be just around the corner.