Something is perking in Washington that could end up costing many people a lot of money that they weren’t expecting to spend. If you own assets that have appreciated in value, this could be you.

As I write this article news outlets are running stories regarding changes to capital gains that will affect “the wealthy” (see this in the Wall Street Journal or this at CNN as examples). As I will explain, this will have an impact on many of my clients who do not consider themselves at all wealthy.

First, either tell yourself you know about the tax basis rules and how they relate to capital gains taxes. If you can’t do that, take a few minutes to go back and read my article on capital gains basics.

Sen. Chris Van Hollen is circulating for comment a bill that would cause immediate capital gains taxation upon gifting and at death. Rep. Bill Pascrell has introduced a very similar bill in the House. The Biden administration backs the proposals. Both bills incorporate ideas that have been tossed around for years. The Senate version is called the “Sensible Taxation and Equity Act of 2021” or “STEP Act.”

The Senate version would be retroactively effective and apply to transfers made on or after January 1, 2021. The House version would apply to transfers after December 31, 2021.

If a variation is enacted, the 100-year-old stepped-up basis rules will be history. Although both bills are being promoted to ensure “the rich pay their fair share” more than the rich will pay. Read this to find out if you could be affected.

Background

As I discussed earlier, the US tax system has historically not taxed appreciation in property until the property has been sold. Further, taxable appreciation of property is completely wiped out upon an owner’s death.

Example #1

As shown in my earlier post, if Edith and Ralph Flimster bought a 100 acre farm in 1972 for $50,000, and later sold it for $220,000, they would have $170,000 taxable capital gain.

If they gift the farm to the children, Jimmy John (“Sammich”) Flimpster and Janey Ack Flimpster-Cellar (“Janiac”), they will also receive their parents’ tax basis along with the farm. If they turned around and sold it for $220,000 they would have $170,000 capital gains.

If Sammich and Janiac inherited the farm (either directly from Edith and Ralph or through a trust upon the death of Edith and Ralph) their basis would be the fair market value on the date of the death that triggered the inheritance. If Edith and Ralph died immediately, Sammich’s and Janiac’s basis would be $220,000. If they immediately sold the inherited property for $220,000 they would have ZERO capital gain.

That is what President Biden and Senators Van Hollen and Pascrell want to stop. They say it is directed to “the rich” but if enacted it will have an impact on many not-so-rich.

How the Bills Work

Capital gains would be subject to immediate tax any time property is transferred, whether by gift or at death, unless an exception applies (transfers between spouses) or a dollar exemption applies (discussed below).

The rates for most of us will stay the same (0% if taxable income – including any capital gains – is less than $40,000 for an individual; 15% if total taxable income is less than $445,851; 20% over that amount). The Biden administration proposes to raise the rate to 39.6% on incomes over $1 million (but remember that includes capital gains).

Dollar Exemptions

The STEP Act will give all taxpayers a $100,000 lifetime exemption and allow a $1MM exemption at death (MINUS any of the $100,000 lifetime exemption used earlier).

Basis in New Hands

Once a transfer has been made and subjected to the tax (or an exemption), the basis in the hands of the transferee is the value of the asset used for calculating the tax.

Example #2

As shown above, if Edith and Ralph Flimster bought a 100 acre farm in 1972 for $50,000, and later sold it for $220,000, they would have $170,000 taxable capital gain. Those rules haven’t changed.

But if they gift the farm to Sammich and Janiac, Edith and Ralph will have $170,000 taxable gain. However, each of them has a $100,000 lifetime exclusion. The statute isn’t explicit, but my guess is regulations would sort this out as follows:  Each of Edith and Ralph would contribute $85,000 of their $100,000 exclusion to wipe out any tax due (85,000 x 2 = 170,000). That leaves each of them with $15,000 lifetime exclusion and Janiac and Sammich with a $220,000 basis going forward.

Example #3

The following year they gift the kids stock worth $80,000 that they purchased years earlier for $10,000. The gain recognized will be $70,000. Each of Edith and Ralph use up their remaining $15,000 exclusion ($30,000 total), leaving $40,000 taxable. Their federal taxes alone will be $6,000 (assuming a 15% rate). If North Carolina elects to dovetail with the federal scheme, there could be another $2,100 state tax due (at 5.25%). The kids’ basis in the stock will be $80,000.

Example #4

The following year Ralph dies. His will leaves everything to Edith. Spousal transfers, recall, are exempt from gain recognition.  Edith inherits the existing basis in all the assets.

The following year, Edith dies and leaves everything to the kids. Because it is the year of her death, she has an exemption of $1,000,000 LESS the $100,000 lifetime exemption she used. Her estate consists of Flimpster Carpet Cleaning Solutions, Inc. (10 employees and a manager) that Ralph started in 1967. Arnold Abacus, the accountant says the fair market value is $1,500,000 and the basis is $150,000.  That’s $1,350,000 built-in capital gain.  There is also the family residence purchased in 1972 for $35,000 and now worth $250,000. That’s another $215,000 built-in capital gain. A total capital gain of $1,565,000.

After subtracting the $900,000 of the available exemption amount, the capital gains subject to taxation at Edith’s death will be $ $665,000. Sammich and Janiac will need to come up with $99,750 to cover the federal capital gains tax on $665,000. That’s the bad news. The good news is that the STEP Act would allow them to finance it with the IRS over 10 years.

Trusts

How the STEP Act treats trusts depends upon what kind of trust is under review. In my practice, I use both “grantor trusts” (trusts that for income tax purposes are treated the same as the person who set it up – everything goes on the Form 1040 of the person who set up the trust) and “nongrantor trusts” (trusts treated as separate tax entities. There are advantages and disadvantages to both. Either, if properly drafted, can do a good job of protecting assets (say, from nursing home costs).

The STEP Act says a transfer to a nongrantor trust will trigger tax. A transfer to a grantor trust will NOT trigger the tax.

Example #5

After Ralph’s death, Edith panics and transfers the residence to the kids “for safe keeping in case I need to go to a nursing home.” At the time she owns very few other assets. Recall, they bought the home for $35,000 and it is now worth $250,000. If Edith still has her entire $100,000 lifetime exemption, she’ll have gain of $115,000 (250,000 – 35,000 – 100,000). The federal bite will be $17,250, due immediately!

A Better Way

Instead of panicking Edith looks for good legal and tax advice. To protect the residence for Medicaid purposes, Edith should transfer the residence to an irrevocable trust. If the trust is carefully drafted as a “grantor trust” there will be no taxes due on the initial transfer.

If Edith dies later when the residence is worth $275,000, there’ll be capital gain of $140,000 (275,000 – 35,000). HOWEVER, because this is the year of her death, there’ll be an exemption of $1,000,000 to apply and there will be NO (ZERO) tax due.

Conclusion

The STEP Act, if enacted, will upend century-old rules regarding capital gains taxation. Contrary to political rhetoric, the Act will affect many more than “the wealthy” because people of ordinary means will pay for transfers of family property.

Stay tuned.