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Retroactive Changes to Tax Policy May Significantly Impact Gift and Inheritance Transfers

June 30, 2021
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In May, the Biden administration released its Green Book containing the President’s policy and revenue proposals. The proposals include many changes, but the most significant includes the loss of a step up in basis and the increase to the capital gains tax. The changes include the following:

  • The change to the step up in basis proposes that the transfer of any appreciated property inherited upon death would be a taxable event.
  • The change to the capital gains rate includes increasing the tax on long-term capital gains from the current rate of 23.8 percent to a new rate of 40.8 percent.
  • There are no proposed changes to the gift and estate tax.

Proposed Changes to the Step Up in Basis

A step up in a basis provides a big benefit to individuals inheriting assets upon the death of a loved one. The Green Book proposes to eliminate this step up in basis with a lifetime exemption of $1 million for individuals and $2 million for married couples.

Assets inherited typically have increased in value since the decedent purchased the assets. An example of these assets includes real estate purchased 30 years prior or stocks purchased at a low value. If the individual were to sell the asset before death, there would be a long-term capital gain because of the sale. This gain would be taxable.

Typically, these assets are retained and inherited upon the death of a loved one. Under the current tax law in the Internal Revenue Code Section 1041, the inheritor receives a step up in basis. This means their basis in the property is the “fair market value of the property at the date of the decedent’s death.” I.R.C. Section 1041. Practically, this step up in basis either eliminates or reduces the tax bill. Losing this step up in basis could be significant for individuals inheriting highly appreciated real estate, stocks or other investments.

Although on paper this elimination seems to target wealthier individuals, it could affect middle class individuals as well. An example of this is a child who earns a modest salary but inherits her mother’s home purchased in 1970 for $200,000. Upon her mother’s death, the home is worth $2 million due to its appreciation. Under current law, the child would inherit the home and could sell it immediately for $2 million without a taxable event. Under the Green Book’s proposal, capital gains would be due on the sale of the home on the $800,000 capital gain taking into account the basis of $200,000 and the $1 million exemption. This $800,000 capital gain would be taxed at the highest bracket of the new proposed rate of 40.8 percent, resulting in a tax due of approximately $325,000.

Proposed Changes to Capital Gains Rate

The Green Book proposals include changing the capital gains rate from 23.8 percent to 40.8 percent. This tax applies to long-term capital gains on appreciated property held for more than one year. This increase would apply to certain high-income individuals – for those with adjusted gross income exceeding $1 million filing jointly and exceeding $500,000 filing individually or married filing separately. This increase could potentially rise further with the 3.8 percent investment surtax on higher income individuals. This would raise the 40.8 percent to 44.6 percent.

The proposals also include a realization of capital gains by the donor at the time of the gift. Practically, this means a gift transfer would be treated as a realization event as if the property was sold.

Gifts or bequests to charities would not trigger a realization event. Additionally, gifts or bequests to spouses would not become a realized gain until the death of the spouse or disposition or sale of the property. In both cases, the basis would carry over.

These changes may also significantly reduce the benefits of certain tax planning entities such as Dynasty Trusts. The Green Book proposals include imposing a realization event every 90 years on unrealized appreciation of property owned by a trust, partnership or non-corporate entity. The realization period would begin Jan. 1, 1940 resulting in the first tax due on Dec. 31, 2030.

These changes to the capital gains rate are proposed to apply retroactively relating back to the date of the announcement or release of the proposals.

Retroactive Changes to Long-Term Capital Gains

The Green Book’s proposed change to long-term capital gains is retroactive. These changes would relate back to April 28 or May 28, 2021. This change is significant because it would be the first retroactive capital gains increase in US federal tax history. The most significant effect of the retroactive change is that it renders any planning very difficult.

The law does allow for retroactive tax changes. Congress has broad authority to set policies as it sees fit within its constitutional limits. Article I, Section 9 of the United States Constitution does state that ex post facto laws shall not be enacted. The Supreme Court Case from 1798 Calder v. Bull, 3 USC.386 (1798), interpreted this provision of the Constitution and held that the limit to ex post facto law changes only applied to criminal matters.

More recent United States Supreme Court Cases United States v. Hemme, 476 U.S. 558 (1986), Welch v. Henry, 305 U.S. 134 (1938), and United States v. Carlton, 512 U.S. 26 (1994), have all held that income, estate and gift taxes may all be enacted retroactively so long as there is a rational basis for the changes. This justification is relatively easy to satisfy and will not prevent these proposed policies from being enacted retroactively.

How Will This Affect Your Gifts or Transfers?

The practical effect of this increase will be significant. It will affect capital gains due to sales of appreciated assets and appreciated assets transferred upon death through an estate. The following example outlines the effect of these tax changes.

  Current Law Proposed Changes
Fair Market Value of Gift $5 million $5 million
Donor’s Basis $1 million $1 million
Realized Gain $0 $4 million
Exclusion $0 $1 million
Rate 0 40.8%
Tax Due $0 $1,224,000

 

In this example, under the current law, no tax would be due. Calculating the same under the proposed changes, there would be a gain of $3 million after excluding $1 million and result in a tax due of $1,224,000.

In light of these proposals, it is more important than ever to stay connected with your trusted advisors to stay informed about these changes and how it may impact your plans.

If you have any questions about these changes and the impact on your income, estate or gift tax planning, or estate planning in general, please contact Erika Apelis at 216.978.5353 or efa@kjk.com.

 

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