This post is not intended to be political, however, to some degree politics may be difficult to avoid. In short, there is a time bomb in Joe Biden’s proposed tax plan that will hit virtually everyone very hard.
For those who simply listen to Joe Biden and Kamala Harris say they will only raise taxes on people making over $400,000 per year, here is the current reality. The Biden tax plan, as currently proposed, is set to roll back the estate tax exemption limits of the Tax Cuts and Jobs Act (“TCJA”). How much? We’re not sure yet. At present the exemption is roughly $11.5 million per person. There are two possible scenarios with this exemption. One, roll it back to the $5.5 million per person exemption that was in existence prior to the TCJA. The second option is to reduce the exemption back to $3.5 million per person. The latter is reportedly the Democratic party’s preferred exemption level.
Now, for a lot of people none of this is any big deal. The lower exemption levels will, however, hit many Puget Sound families and many will need updated estate plans.
But estate tax exemptions aren’t the time bomb to which I’m referring. The time bomb is Joe Biden’s currently proposed plan to end the step-up in tax basis when a person dies. As if this proposal isn’t bad enough the plan also calls for tax to be paid on the unrealized gain and not when the asset is sold. If you don’t think this is a nightmare time bomb, think again. This tax plan, as currently proposed, will impact people in the Puget Sound region hard.
If you are thinking “What is this guy talking about?” allow me to explain. Under current, long standing, tax law, when you purchase an asset such as a house or a share of stock the price you pay becomes your “tax basis.” So if you are an older married couple and bought your house in 1974 for $50,000 that is your tax basis. When either spouse dies the IRS automatically allows the tax basis to increase to the current fair market value. Let’s say in 2020 that same house is worth $750,000. On the death of one spouse (or the owner if there is only one) the tax basis will increase from $50,000 to $750,000. On any subsequent sale of the property only the difference between the sale price and the new tax basis would be subject to capital gains taxes. Great deal.
Under Biden’s proposed plan the tax basis will remain $50,000 when one spouse dies. To really add insult to injury, the unrealized gain (meaning you have not sold the property and do not have cash from the sale) will be taxed. Holy moly!! Under our hypothetical scenario, $700,000 of gain will be taxed on the death of the first spouse. The rates on capital gains depend on your income, but let’s just assume the well known 20% capital gains tax rate. That’s $140,000 mom owes Uncle Sam when dad dies!!
Keep in mind that mom may actually want to keep living in her own home. What is she supposed to do? Well obviously she’ll have to dip into her other assets to pay the tax. So let’s say mom and dad had a $1 million total estate. $750,000 worth of house and $250,000 in cash and stock. Of the $250,000 mom has left to live out her golden years, $140,000 will have to be paid to the IRS. That leaves her with $110,000. But wait, there’s more!! If mom’s remaining assets include appreciated Amazon, Boeing and Microsoft stock all of increase in value of those shares will be taxed as a capital gain (remember this doesn’t just apply to real estate but stocks, bonds, business interests, and anything else that is an “asset”).
In short, if mom wants to stay in her home, she’ll now have less than $100,000 to live out her days. What if that stock is in an IRA you ask? Won’t she avoid capital gains on the stock? Correct. But when mom has to pull the $140,000 out of her IRA to pay the tax on the house, that $140,000 will be income to her in the year received. Her tax bracket will jump significantly – probably into the 28% or more range. Meaning subtract another 28% from the $140,000 ($39,200). Mom will actually have to pull more money from her IRA (and pay the corresponding income tax) to cover all the taxes when her husband dies.
If you are wealthy this is just one huge disaster waiting to happen. Because in addition to all of the above, the Biden tax proposal is to increase the capital gains tax rate to 39.6% for high income earners. So you may wind up having to sell your vacation cabin, your investment real estate and/or the family business (or those highly appreciated shares of Amazon stock) to pay the tax bill when a loved one dies.
What, if anything, can be done to deal with this? I won’t state the obvious, so here is at least one strategy. Make lots of gifts. For wealthy individuals this will work just fine. There are lots of planning options. For our $1 million mom and dad hypothetical we discussed above, this won’t be so fine. In fact it could be just as big a problem as the paying the tax.
Let’s say mom and dad give their house to their children and rent it back from them. The first problem is Medicaid’s 5-year look back rule. In this scenario, the gift of a $750,000 house will disqualify mom and dad from obtaining Medicaid to help pay for long term care for 5 years. So pray you don’t need long term care in your later years. The lease will need to be totally above board, at fair market rent, and of course mom and dad are now completely at the mercy of the kids because they can be evicted at any time. One problem I’ve encountered advising in these situations is that mom and dad don’t have any interest in putting their lives in the hands of their kids.
There are other problems with gifting the house to the kids. First, the house will be exposed to the creditors of the children. Second, the house will be exposed to any divorce proceeding the kids may have to go through. And third, if there are multiple children, the kids will be partners in a “business” venture and they may not always see eye to eye. Of course there are ways to plan for these problems, but we may not be able solve every problem.
Maybe Trump will win re-election. Maybe the Republicans will retain the Senate. Or maybe sanity will poke its head out of the hole and the final version of this plan won’t be as bad as stated. If none of that happens, everyone, not just the rich, will need extensive tax and estate planning.