Death, Taxes, and Touchdown!


Volume 92 No. 5 - May 2021



05-2021 Newsletter
.pdf
Download PDF • 621KB





President Biden came to office with big promises. Beyond ending the pandemic, he also promised sweeping changes to childcare, paid family leave, and the cost of a college education. But change costs money. To fund his $1 trillion American Family Plan, President Biden has proposed changing the way we tax capital gains. The headlines this month have brought the prospect of higher taxes to the forefront of the news.


The proposed tax changes would deliver on Biden’s campaign promise to tax “wealth, not work” and raise taxes on America’s corporations and wealthiest taxpayers. While lawmakers refine and discuss the landmark plan, we’ve received a lot of questions about what it means to the American public:

• Will President Biden stay true to his campaign promise not to raise taxes on Americans earning less than $400,000 a year?

• Will middle-class taxpayers pay higher taxes to finance the historic spending incurred by our

federal government in 2020 and 2021?


Taxes are like sports. To play a fair game, you need to know the rules. When the rules change, you need to change your strategy. If you don’t, it’s hard to score touchdowns, and you may even incur penalties. Read on for more about these proposed new rules:


The Tax Changes You’ve Asked About

When clients ask us about President Biden’s tax changes, most questions coalesce around changes to:

• Capital gains taxes

• Stepped-up basis tax code


As investors, we pay capital gains taxes on the profits we generate when we sell assets like stocks. The tax code’s stepped-up basis provision determines the taxes we pay on property or investments we inherit. With the stepped-up basis provision, we pay capital gains taxes only on the sale gains an asset has realized since date-of death—not since it was originally purchased, potentially decades ago.


Let’s look at what President Biden’s proposal considers changing:


Proposed Changes to Capital Gains Taxes

The tax treatment of capital gains is determined by how long an underlying asset is held. If you sell the asset within one year of purchase, those “short-term” capital gains get taxed as ordinary income. If you sell the asset after one year, you pay “long-term” capital gains taxes. Those tax rates are considerably lower—0%, 15%, 20% or 23.8%, as determined by your income.


What Changes if President Biden’s Proposal Goes Through?

President Biden wants to add another tier to long-term capital gain tax rates. For people who earn more than $1 million a year, Biden’s proposal increases their long-term capital gains tax to 39.6%, not including the 3.8% investment surtax already in place on higher-income individuals.


The Bottom Line:

While President Biden’s proposed changes to capital gains taxes will almost double these taxes for high earners, capital gains will stay unchanged for the country’s middle class earning less than $1 million a year.


The Stepped-Up Cost Basis

Why does the stepped-up cost basis exist? There are two reasons:


1. Family farms. Farms, historically, have been passed down within families. With the stepped-up cost basis, inheritors pay taxes based on the value of the property when they acquired it—

not when it was acquired, potentially generations and centuries ago. One original argument

supporting the stepped-up cost basis came from people and lawmakers who didn’t want to see farmers sell family farms just to pay the taxes incurred by simply inheriting them.


2. Inheritances. Suppose you inherited stocks with a then-market value of $90,000 from your

parents a few years ago. Assume they bought that stock at $10,000 and you sell the stock

for $100,000 today. Right now, you would pay capital gains tax on the $10,000 gain you’ve

realized since inheriting the stocks—instead of the $90,000 gain that the stocks have seen since your parents bought them years ago. Proponents of the stepped-up cost basis argue that you should not have to pay taxes for the change in the value of an asset or property when it was not under your control.


What Changes if President Biden’s Proposal Goes Through?

Under President Biden’s proposal, you could face a larger tax bill on inherited property regardless of how much you earn a year. Even on real estate, the $500,000 exemption on real estate capital gains (if filing jointly) only applies if the home has been your primary residence for two of the last five years.


As it is written now, the proposal will raise taxes for some middle-class Americans. However, several senators have proposed allowing a $1 million per person exemption, thereby redirecting this new tax burden to much higher inheritances.


The Bottom Line:

The outcome of the proposed stepped-up basis tax changes depends on the final bill’s wording when it is passed. The change could very much impact middle-class taxpayers when they inherit property. However, scenarios are being discussed that would limit the impact of the change on middle-class Americans.


An Important Impact

President Biden has largely targeted the impact of these tax changes toward higher-income, higher net-worth individuals, as he promised on the campaign trail. However, as it is written, the stepped-up cost basis could impact middle-class taxpayers directly. That bears watching as lawmakers determine the outcome of these changes in coming months. We will continue to monitor these developments as they progress.


Conclusion: Biden’s Social Programs Come with a Cost

The very real societal, human, and financial costs of the pandemic have raised America’s awareness of its social safety net. As we grapple as a country to find the right balance between the extent of our social programs and the taxes we need to fund them, lawmakers will make decisions and compromises.


We will monitor these proposed tax changes with your investments in mind. As always, we stand ready to answer your questions and discuss your concerns.


As of this writing, nothing has changed, but the extent of the impact of these tax changes on middle-class taxpayers bears watching. We should watch whether the culling of the stepped-up cost basis comes with an exemption up to a certain amount of money. If you hold a large quantity of appreciated stocks or long-time real estate, the future of the stepped-up cost basis could inform your strategies around investments and generational planning.


In investing—like sports—we need consistent, transparent rules. Rule changes invite discussion, debate, speculation, and sometimes worry. A change in capital gains taxes could mean a change in tax liabilities on assets you currently hold or will hold in the future. The situation is not unlike a group of referees huddling together at halftime to discuss changing the definition of a touchdown and making it retroactive to the start of the game.


We all wait together to see how Washington hammers out this new tax proposal. Anticipate volatility as the referees decide the future of our investments, mid-game!

Investment Counsel Inc. is a registered investment adviser. Information presented is for educational purposes only. It should not be considered specific investment advice, does not take into consideration your specific situation, and does not intend to make an offer or solicitation for the sale or purchase of any securities or investment strategies. Investments involve risk and are not guaranteed. Be sure to consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein.