Big tax bills to hit even modest inheritances if step-up in basis narrows

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The widow living on a comfortable-but-modest income who wants to give her children the Cape Cod house she inherited from her father decades ago. The octogenarian husband and wife who plan to bequeath to their grandchildren half of the $3 million stock portfolio they built through a lifetime of scrimping and saving. The owner of a small vineyard in Napa Valley who aims to give the second-generation family business to his niece and nephew.

Not just the offspring of the wealthiest 1% of Americans — an estimated 1.4 million households with an annual income of at least $539,000 and a much higher net worth, according to one measure — stand to suffer from President Joe Biden’s proposal to tighten up the tax loophole known as step-up in basis. So do millions of other well off but decidedly less rich individuals.

“Most clients are, ‘you’ve gotta be kidding me’,” says Edward Renn, a partner in the private clients and tax group at law firm Withers in New Haven, Connecticut.

Biden wants to end the basis “step-up" for individuals who inherit assets with untaxed gains of more than $1 million ($2.5 million for couples). Data show, and advisors say, that the change would put a buzz saw to the future money tree of tens of millions of Americans.

Bloomberg News

Compounding the pain is Biden’s companion proposal to tax the long-term capital gains on investment and other profits of more than $1 million at a new top individual rate of 39.6% (43.4%, including the Obamacare surcharge). The hike, a near-doubling from the current capital gains rate of 23.8%. Unusually, the new rate would take effect this April — retroactively. The higher top individual rate, up from the current 37%, would also hit labor income over $400,000, according to proposals laid out on April 28.

“Inheritors are going to get killed,” says CFP Kenneth Van Leeuwen, the managing director of Van Leeuwen, an RIA in Princeton, New Jersey.

Under the current law, individuals who inherit assets don’t owe tax on their gains that materialized from the time the original owner acquired them. The value of the assets is “stepped up” from its original (lower) cost “basis” to its current (higher) price. This long-standing loophole has allowed family fortunes large and small to be passed down to the next generation. For individual heirs of estates below $11.7 million ($23.4 million for couples), the levels at which estate taxes kick in, the benefit has been an engine of tax-free wealth transfer to future generations for decades.

Exceptions would apply under the proposed rules for businesses or farms that remain in the family, or for property given to charity in exchange for a deduction.

While the retroactive date at which the capital gains hike would go into effect would be April 28, the step-up in basis limit would change for heirs who inherit property from family members who die after December 31, 2021, according to the Treasury Department.

The one-two punch of the tax hikes would hit millions of boomer offspring expected to inherit an estimated $69 trillion over the next three decades — what labor economist Robert Reich calls the largest inter-generational transfer of wealth in history as aging boomers (born between 1946 and 1964) retire.

Financial Planning

Biden’s focus on taxing billionaires and “the rich” takes a redistributive approach that might seem to be aimed only at heirs to the dynastic fortunes of Walmart, Pritzker and DuPont, or the Forbes 1000.

But beneath those sky-high fortunes held by few lie cushions amassed by the so-called mass affluent, defined by Goldman Sachs as those with income or investable assets between $100,000 and under $1 million.

Nearly 1.2 million households have an income between $500,000 and $1 million, according to the most recent IRS data. More than 503,000 have income between $1 million and $5 million. In terms of net worth, not income, at least 20 million U.S. adults now have a net worth of over $1 million, according to Credit Suisse’s Global Wealth Report 2020. That’s more than 8% of the U.S. adult population. In 2019, families in the top 10% of U.S. households by wealth had a median net worth of nearly $1.6 million, Federal Reserve data show.

The issue is that houses have exploded in value since they were bought decades ago and stock portfolios, like real estate, will likely grow even larger before being given to heirs, putting them past the new tax limits, if they aren’t already there now.

Experts at the Urban-Brookings Tax Policy Center estimate that the basis step-up proposal would hit 2% of decedents who make less than $400,000 — a group for which Biden has pledged not to raise taxes. The Tax Foundation, a conservative think tank, estimates that the step repeal, higher capital gains rate and 40% estate tax would result in a 61% rate for those at the top end of the scale, the highest in almost a century.

Van Leeuwen cites the example of a middle-class family in Fairfield County, along Connecticut’s affluent “Gold Coast.” A home they bought two decades ago has likely at least doubled in value over the past two decades. In wealthy Greenwich, the median house price in 2020 was more than $2 million, more than twice 2001’s $995,000, according to local property records. The tax hikes “will have a huge impact on homeowners,” he says.

Wealthy investors who own trusts would also be hit. But on that front, they get a heads-up, which advisors say could create tax planning opportunities. The administration wants to levy capital gains tax on unrealized appreciation of property held in trusts, partnerships and other non-corporate entities if the property hasn’t been taxed within the previous 90 years since 1940. Individuals would thus owe tax under this provision starting on December 31, 2030. “Grandma put the Cape Cod compound into a trust 90 years ago, and now the trust is going to get taxed on it,” says Renn.

The proposals have to pass Congress, where a slim Democratic majority, with some Democrats in wealthy states, threatens to create a whopper of a tax fight, and many advisors view the draft rules as an opening poker bid. While retroactive tax hikes are unusual — the last one was in 1993 under the Clinton administration, and was for individual rates — there has never been one for capital gains tax, Renn says. The basis step-up loophole has origins dating back to 1921, when the long-term capital gains tax, levied on assets held for a period of time, now one year or longer, was introduced.

Biden’s proposals “already face stiff opposition, which makes it more unlikely Congress would take the step of making them retroactive,” says Bob Oros, the chairman and CEO of Hightower Advisors, an RIA in Chicago. He theorizes that ”one could argue that President Biden could have simply announced the increase that day, if he intended to put it into place.”

If they ultimately become the law, some investors may have to absorb tax hits that could have been avoided. “The clients may not have sold assets, particularly low basis holdings, had they been aware of the retroactive rate change," says Laura Godine, a vice president and the director of wealth planning at Eaton Vance WaterOak Advisors. "Now they may already be stuck with a potential high tax hit.