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.
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.