Authors: Jenna-Rose Finnie & Jonathan Harrington

On April 28th President Biden pitched his American Families Plan to a select group of members of Congress. Near the end of the proposal was a section entitled “End capital income tax breaks and other loopholes for the very top.”  The first part of this section covered changes to capital gains tax rates that we covered in a previous blog article. The second part covered closing the “step-up” loophole (see text below) which is what we’re going to cover in this week’s blog.

The President’s plan will close this loophole, ending the practice of “stepping-up” the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity. The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business. Without these changes, billions in capital income would continue to escape taxation entirely.

A related piece of legislation introduced by Senator Chris Van Hollen is called the Sensible Taxation and Equity Promotion (STEP) Act . The objective of the bill is to close the “step-up loophole” by amending the tax code so that “any property which is transferred by gift, in trust, or upon death should be treated as sold for its fair market value to the transferee on the date of such gift, death or transfer.”

Since a draft of this bill has been released we’ll cover the provisions in it to inform readers of what changes may be coming in it, the American Families Plan or other legislation designed to close the “step-up loophole.”

If any of these proposals are codified into law, the way accountants, estate planning attorneys, and financial planners approach tax minimization and gift and estate planning is going to change dramatically.

What is the step-up in cost basis rule?

The term “cost basis” refers to the original purchase price of an asset, such as a share of stock or a piece of property. When the asset is sold, the owner pays capital gains tax on the difference between the sale price and the cost basis.

In cases where an asset is inherited, the cost basis is stepped up to the value at the date of death (or an alternate valuation date). Assuming the asset has increased in value between the purchase date and the date of death of the original owner, this can significantly reduce the tax burden on the recipient. The step-up rule is an incentive to hold on to highly appreciated assets and is a bedrock of estate planning tax reduction strategies.

When an asset is gifted to someone else or transferred to a trust, the basis is carried over and retains its original cost basis. If the recipient of the asset is in a lower tax bracket than the donor, they can sell the asset and benefit from a lower capital gains tax.

What is a capital asset?

A capital asset is a valuable piece of property such as a house, cars, investment properties, stocks, bonds and collectible art.

It’s important to note that this proposed legislation only applies to capital assets such as stocks, bonds, mutual funds, ETFs that are held in a taxable, non-retirement type account. Other capital assets include real property, business interests, collectibles, commodities, and precious metals.

Assets where growth is taxed as ordinary income such as IRAs, 401(k)s, annuities and whole value life insurance would still be taxed the same way.

What could change?

The bottom line in these proposals is that at a person’s death, or when an asset is gifted or transferred to trust, the asset will be treated as if it were sold and recognized on the taxpayer’s final tax return (in cases of an estate) or current year tax return (in the case of a gift) or the trust tax return (in cases of a transfer to a trust).

Whatever the applicable capital gains tax rates in place at the time will apply to these recognition events.

When the assets are transferred to the new owner, the new basis will be equal to the value that was taxed.

Non-grantor trusts could be subject to deemed recognition which means that assets held in a trust would periodically have to recognize capital gains on the full appreciation of assets in the trust. The STEP Act language calls for this to happen every 21 years and being retroactively applied to non-grantor trusts that were in existence as of 12/31/2005.

There are always exceptions…

The STEP Act does carve out several exemptions and exceptions that reduce what might otherwise be subject to the new capital gains realization rules.

1. Standard Exemptions: T hese exemptions apply to gains, not the value of the asset.
   1. Lifetime Gifts or Transfers : $100,000 per individual (cumulative, not annual)
   2. Year of Death: $1 million per individual. It is not clear if this will be portable to a spouse if not fully used by the first to die.
2. Spousal Exemption : Any assets that are transferred to or inherited by a spouse would be exempt.
3. Tangible personal property : The proposed rules are not applicable to tangible personal property other than collectibles.
4. Charitable Donations : Assets donated to a charity during lifetime or at death would be exempt from capital gain realization.
5. Family businesses and farms : This wasn’t clearly written into the STEP Act draft, but Senator Van Hollen has proposed giving an estate or donors up to 15 years to pay for the capital gains tax that would apply to transfers of illiquid assets like farms or a business.
6. Revocable Grantor Trusts : Assets that are transferred to grantor trusts would not be subject to capital gains realization because they are still considered as owned by the donor.
7. Estate Tax Deduction : Any capital gain taxes paid on a decedent’s final tax return would likely be allowed as a deduction for estate tax purposes to avoid double taxation.

Solutions

As with any changes to how income is taxed in the U.S., there are always opportunities to adjust and try and minimize taxes paid. Some ideas for reducing the gains that could be subject to these proposals include:

1. Periodic gains realization : As people approach the end of their life expectancy, they could start recognizing gains of appreciated assets at lower rates instead of running the risk that cumulative gains at death would be subject to the highest capital gains tax rate which has been proposed to go as high as 39.6% by the Biden Administration.
2. Charitable Contributions : If you are charitably inclined, you could donate your highly appreciated assets to charity directly or through a charitable remainder trust.
3. Installment Sales : If you are an owner of a business or real estate, you could consider an installment sale to spread the gain over time.
4. Maximize Retirement Plan Contributions : During your lifetime, ensure that you are maximizing retirement plan contributions, especially to Roth accounts.

Final thoughts

The STEP Act and the American Families Plans are still only proposals. However, some or all of the proposed legislation may become law in 2021 and it is important to consider how we would adapt planning strategies to minimize the taxes paid by our clients. Proper planning prevents poor performance! Stay tuned!

Jenna-Rose Finne & Jonathan Harrington, CFP® is an advisor at Milestone Financial Planning, LLC, a fee-only financial planning firm in Bedford NH. Milestone works with clients on a long-term, ongoing basis. Our fees are based on the assets that we manage and may include an annual financial planning subscription fee. Clients receive financial planning, tax planning, retirement planning, and investment management services, and have unlimited access to our advisors. We receive no commissions or referral fees. We put our clients’ interests first.  If you need assistance with your investments or financial planning, please reach out to one of our fee-only advisors .