Step-up In Basis: Estate Taxes and the Great, Big, Scary Government in 2021
Estate taxes have for a long time, been generally unpopular in the U.S. because they break the sacred rule of ‘tax once and only once.’ Essentially, an estate tax compels families to pay taxes on money that has already been taxed. If an individual in the country is wealthy enough to leave an inheritance to their family, the IRS will tax them once when they make the money and, if they meet the Estate Tax threshold, again upon their death and transference of their wealth to their children. While this may not be a popular policy, it has nevertheless been championed by current and previous federal lawmakers as a way to get the ‘wealthy’ to “pay their fair share”. Now it would seem that the entire applecart has been tipped over by the Biden administration with their modern estate-tax proposal involving the “step-up in basis rule” which would affect people who fall below the threshold. What is the likelihood that this proposal will become law and what can we do to protect our clients’ legacy if it does? Let’s start with a basic understanding of the details and how they might affect your clients.
The end of the “step-up in basis” rule
One of the key changes that would have an impact on the tax burden of your client’s beneficiaries is the proposed repeal of the ‘step-up in basis’ rule. What is the step-up in basis rule? Here’s an example:
Let’s say that your client purchased a home in 1991 for $200,000. Over the next 3 decades, the home appreciates considerably and when the client passes away in 2021, the home is valued at $800,000. The client’s children inherit the house as part of the estate. The ‘step-up in Basis’ rule means that the children will pay estate taxes on the original purchase price ($200,000) of the home. The additional $600,000 of value that the home has accrued would not be taxed.
What does repealing the step-up in basis rule mean for my clients?
If the current proposal ever passes, the beneficiaries of family homes that have appreciated in value will face a steep tax burden based on the accrued value gains of the home. In our example above, capital gains taxes on the $600,000 increase in home value would have to be paid. In some cases, it may be too great a burden to pay without selling the family home outright in order to cover the tax bill. Your client may not wish to put his/her children in a difficult tax situation upon their death.
Will repealing step-up in basis affect businesses?
The short answer is, “Yes.” Significantly. Let’s take a moment to think about family-owned businesses such as farms and ranches. The value of a family-owned farm could easily be in the millions. If it has been in the family for many generations, then the step-up in basis rule protects the later generations from paying taxes on the value that has accrued for several decades. If suddenly this rule was repealed, it is likely that many of these farms and ranches will go out of business entirely. The Texas Farm Bureau states that,
“The magnitude of the tax burden that would be felt if basis is taken away or reduced would likely significantly exceed the annual income generated by the assets, something that has American farmers concerned.”
Assets of all kinds will be taxed
Beyond the farmers, other assets also enjoy the step-up rule. People who have put assets in a trust for their heirs to avoid paying capital gains will be impacted by a repeal as well. The resulting capital gains tax burden could be devastating for your clients’ heirs if they have substantially appreciated in their lifetime. If a savvy mother purchased $1,000 of Amazon (AMZN) stock in 1997, it would be worth a staggering $2.1 million today. Without the step-up rule, that could amount to a tax bill of hundreds of thousands of dollars, possibly forcing liquidation of those assets to pay for it.
How can we help clients protect their legacy?
While this proposal has yet to make it through the House and Senate and may not ultimately pass, the proposal itself is a reason to better prepare your client for any eventuality. An obvious choice, of course, would be to have your client consider a second-to-die policy for the express purpose of keeping the estate intact for their spouse and heirs. Second-to-die policies are more affordable than single life and lend themselves to covering estate taxes.
Clients concerned about their proceeds from their life insurance policies adding to their taxable estate could make use of a life insurance trust to shield them from the taxes. By transferring a policy into a trust (or creating the trust and then purchasing the policy through it), a wealthy client may be able to lower the value of their estate and reduce their tax burden.
One way or another, we should always look forward on behalf of our clients
The takeaway here is clear. At any point in time, political winds could foster monumental change in how our clients’ assets are taxed when they pass away. It is our job to stay on top of current trends while educating our clients on the options available to them. They have worked hard for their money, their homes, and their investments. By understanding all of the possible scenarios and using the tools of our trade, we can help them leave a legacy while helping their families avoid a financial headache.
Trust Financial is here for you. If you have any questions about how to best serve your clients’ needs, we are ready to share our expertise and solutions with you.