Stepped-Up Basis Reform: Proposed Changes

President Biden’s recent tax reform proposal has sparked discussions about its potential impact on wealthy individuals and their inherited assets. One key aspect of the proposal that has drawn attention is the suggested changes to the stepped-up basis loophole. The proposed stepped-up basis reform aims to close this loophole, which currently allows heirs to inherit assets at their current market value rather than the original purchase price, effectively reducing capital gains taxes.

Understanding the "Stepped-Up Basis"

Currently, the stepped-up basis rule allows heirs to reset the tax basis of inherited assets to their fair market value at the time of the decedent’s death. This provision significantly reduces the capital gains tax liability should the assets be sold later, as taxes on the appreciation during the decedent’s lifetime are essentially waived. This loophole not only boosts tax savings on unrealized capital gains but also encourages holding appreciable assets until death for tax advantages.

Stepped-Up Basis Reform Proposed Changes to Taxes

Biden's Proposal: A Shift Towards Equity

President Biden’s tax reform proposal seeks to address this loophole by deeming the transfer of assets upon death—and in certain cases, through gifts—as “realization events.” This means the assets would be considered sold at their market value at the time of the transfer, and capital gains taxes would apply accordingly. The proposal aims to equalize tax treatment across different income sources and wealth levels, ensuring that significant unrealized gains do not escape taxation due to the timing of asset transfers.

Exemptions and Protections

Understanding the potential impact on families and businesses, the proposal includes several safeguards:

$5M Lifetime Exclusion

This exclusion protects smaller estates and ensures that the tax changes primarily affect those with significant unrealized gains.

Spousal Exemptions

Deferring taxes on assets left to a surviving spouse until their death, preserving the stepped-up basis for them.

Charitable Donations:

Remaining exempt from the proposed changes, encouraging continued philanthropy.

Family-owned Businesses

Offering protection for heirs continuing to run the business.

Scenario: Current Law vs. Proposed Changes

Scenario: Current Law vs. Proposed Changes
  • Initial Investment: John’s father purchased stock for $100,000.
  • Value at Time of Death: At the time of his father’s death, the stock is worth $2 million.
  • Current Law Outcome: John inherits the stock, and due to the “stepped-up basis” rule, the basis of the stock is adjusted to its current market value of $2 million. If John sells the stock immediately for $2 million, he owes no capital gains tax because there’s no gain relative to the stepped-up basis.
Scenario Under Biden's Proposal
  • Proposed Change Implementation: John’s father’s death is considered a realization event, and the estate is deemed to have sold the stock at its fair market value.
  • Gain Calculation: The gain is calculated based on the difference between the fair market value at the time of death ($2 million) and the original purchase price ($100,000), resulting in a gain of $1.9 million.
  • Exclusions and Taxes:
    • Assume John’s father has not utilized the $5 million lifetime gain exclusion.
    • The first $5 million of the gain is excluded from taxes, meaning, in this case, the entire $1.9 million gain is tax-exempt due to the exclusion.
Additional Considerations
  • Impact of Exceeding the Exclusion Limit: If the total gain had exceeded $5 million, say a gain of $6 million, the tax would apply to $1 million of the gain ($6 million gain – $5 million exclusion).
  • Tax Rate Application: The exact tax rate depends on the capital gains tax rate at the time. For simplicity, if we assume a 20% capital gains tax rate, a $1 million taxable gain would result in $200,000 of capital gains tax.
  • Spousal and Charitable Exemptions: According to Biden’s proposal, if the stock were left to a surviving spouse or a charity, the realization event would either be deferred (in the case of a spouse) or exempt (in the case of a charity).
Several critical aspects of Biden's proposal:
  • Lifetime Gain Exclusion: The $5 million exclusion significantly mitigates the impact on estates that do not have extraordinarily high unrealized gains.
  • Encouragement for Strategic Planning: The proposal encourages individuals and estates to plan more strategically for asset transfers and realization events.
  • Focus on High-Value Estates: The primary tax impact falls on very high-value estates with gains exceeding the $5 million exclusion limit, aiming to enhance tax fairness and equity.

President Biden’s proposal to amend the tax treatment of inherited assets aims to close a significant loophole in the current tax system, promoting fairness and reducing the ability of wealthy individuals to avoid taxes on capital gains. While the proposal includes mechanisms to mitigate adverse effects on smaller estates and family businesses, its implementation would represent a substantial shift in tax policy.

The content on this site, provided by Able Wealth Management, is purely informational. While we aim for accuracy and completeness, we cannot guarantee the exactness of the information presented. The views and analyses expressed in this blog represent those of the authors at Able Wealth Management. They should not be considered as investment advice or endorsement of any particular financial instrument or strategy. Any references to specific securities and their performance are purely informational and should not be taken as advice to buy or sell.Before implementing any information or ideas presented, we strongly advise consulting with a financial advisor, accountant, or legal counsel. Investing carries inherent risks, including potential capital loss. Asset values can fluctuate over time and may be worth more or less than the original investment. Past performance does not guarantee future results, and Able Wealth Management cannot ensure that your financial goals will be achieved. Information from third-party sources has not been independently verified by Able Wealth Management. Although we trust these sources, we cannot assure their accuracy or completeness.

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Volatility Drag

Volatility drag, often unnoticed by many investors, plays a significant role in the performance of investment portfolios, especially in markets characterized by high volatility. Understanding volatility drag is crucial for making informed investment decisions and managing long-term investment performance.

Understanding Volatility Drag

Volatility drag refers to the negative effect of investment volatility on compound returns over time. It occurs because losses have a more significant impact on portfolio value than gains of the same magnitude. For example, if an investment loses 10% one year and gains 10% the next, the investment will not return to its starting value due to the mathematical asymmetry between gains and losses. This phenomenon underscores the importance of minimizing large fluctuations in investment value to protect long-term returns.

The Mathematics Behind Volatility Drag

The mathematical principle underlying volatility drag is relatively straightforward but profound in its implications for investors. The key concept is that percentage gains and losses are not symmetrical. A 50% loss requires a 100% gain to break even, not a 50% gain. This asymmetry means that volatility (up and down movements in price) can erode the compound growth rate of an investment, even if the arithmetic mean of the returns seems healthy.

Example of Volatility Drag

Consider an investment with the following annual returns: +20%, -15%, +10%, and -5%. While the arithmetic mean of these returns might suggest a modest positive performance, the compound annual growth rate (CAGR) would tell a different story, factoring in the volatility drag and showing a lower effective return than the arithmetic mean would suggest.

Implications for Investors

  • Risk Management: Understanding volatility drag emphasizes the importance of risk management strategies, such as diversification and the use of derivatives for hedging, to minimize significant downturns in portfolio value.
  • Investment Strategy: Investors might consider investment strategies that aim for steady, consistent returns over those with potentially higher but more volatile returns. Such strategies might include investing in low-volatility stocks, index funds, or using dollar-cost averaging to mitigate the impact of market fluctuations.
  • Psychological Aspects: Volatility drag also highlights the psychological challenge for investors who may overreact to short-term market movements. A long-term perspective is crucial for successful investing, as frequent trading in response to volatility can exacerbate the drag on returns.
  • Performance Evaluation: When assessing investment performance, considering both the arithmetic mean return and the compound annual growth rate (CAGR) can provide a more comprehensive view of an investment’s performance, factoring in the effect of volatility.

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