SIMPLE SUMMARY OF THE “FREE” STEP-UP IN BASIS FOR ESTATE ASSETS AND POSSIBLE CHANGES WITH THE PROPOSED AMERICAN FAMILIES PLAN

Andrew M. Brower

Most of my clients do not have to deal with estate taxes due to the current 11.7-million-dollar exemption per spouse.   Despite this, there are still many important conversations involving taxation that may come up in the initial estate conference at the death of a loved one from deferred income tax with inherited IRAs, fiduciary tax returns, taxation of income earned by irrevocable trusts, and the big one that always comes up and which is the focus of this blog, capital gains taxes. 

Capital gains tax is not an estate tax or related to death at all, but it is still very relevant to estate planning and estate administration.  Capital gains tax is simply a tax paid on the “gain” or profit from the sale of an asset.  In other words, capital gains tax is applied to the difference between what you bought an asset for and what you sell it for. Most North Carolina filers pay a capital tax gains rate of slightly over 20% currently.  By way of example, if you purchased a lot of land for $10,000 in 1984 as an investment and sold it in 2021 for $150,000, you would pay a tax on the $140,000 profit of roughly 20%, or around $28,000.  You should note that there are special rules and exemptions to capital gains taxation related to, among other things, your primary residence and like-kind exchanges.  But the purpose of this blog is to layout the general rules for capital gains taxation.    

The cost basis in an asset is set when you acquire an asset, and it follows the asset if you gift the asset to another person or entity.  Therefore, one disadvantage of gifting assets to another during your lifetime, aside from potential gift and estate tax consequences if you exceed the lifetime exclusion and Medicaid sanctions, is that the donee (person receiving the gift) does not enjoy the benefit of a “free” step-up in basis which would be realized if the donee instead inherited the asset from your estate.

The free step-up in basis for an estate works very simply.  If you inherit property from a parent or other individual, your cost basis in the property becomes the fair market value of that asset on the date of death of the person from whom you inherited the asset.  For assets such as publicly traded stocks, this new basis can be easily determined by examining the historical price indexes on the date of death.  For other assets, including real estate, the date of value may be more difficult to determine and require an appraisal “as of” the date of death.      

The free “step-up” in basis for estates is a huge benefit to heirs who inherit real estate from their parents who may have purchased it in the mid-20th century for next to nothing or who do not have the records to prove their cost basis.  If the free step-up in basis was not available to heirs, many would take a full 20% hit on the proceeds when inherited real estate is sold.  But with the estate step-up rules, prudent heirs who, with help of counsel, carefully document date of death values, usually pay little to no capital gains taxes on inherited assets. 

But this nifty little benefit for heirs could come to an end for some.  Under the proposed American Families Plan, there would be no free step-up in basis for gains of $1,000,000 or more ($2,000,000 or more for a married couple).  Presumably, everything will remain the same for estates with appreciated assets of less than $1,000,000 but the details of the proposal have not been fully laid out at this point.   It has been noted that the capital gains exemption for a primary residence up to $250,000 ($500,000 for couple) will remain intact and that family-owned businesses and farms which the heirs continue to operate will not be subject to the new program.  Additionally, property donated to charity will be exempt.  Some have speculated that the plan would tax unrealized gains at death.  In other words, the death of the owner would be treated as a deemed sale and, therefore, heirs would pay capital gains taxes on assets which have more than $1,000,000 in appreciated value regardless of whether they sell the asset.  There is also speculation that the plan would raise the top capital gains rate to close to 40% for extraordinarily large gains. 

If the free step up in basis were to be eliminated for all estates, it would have a devastating impact for both the wealthy and the middle-class.  The current proposal seems to operate in the vein of the current progressive estate tax scheme, and it appears that it would not impact most estates and many attorney’s planning strategies for the average client.  Additionally, while this is something to keep an eye on for those who may be affected by it, most commentators believe the proposal is unlikely to pass; however, a watered-down version of it could well be reality in the coming years.

If you would like to speak with an attorney regarding planning for these potential changes in the law, call any one of our offices.