In April, President Biden proposed the American Families Plan (the “AFP”), which includes significant changes to the federal tax law. At the end of May, the U.S. Treasury Department issued a report that included some additional information on the implementation and application of some of the proposals set forth in the AFP. Significantly, however, as of this writing, the AFP has not yet been enacted, so it remains to be seen how much of the proposed AFP will actually be passed into law.
For our estate planning and administration practice, the most significant elements of the AFP are the proposed changes to the taxation of capital gains at death. Specifically, the AFP proposes to eliminate the “step-up in cost basis” rule. At the risk of over-simplification, what you pay for an asset is your “cost basis.” If you sell an asset during your lifetime for more than your cost basis, you realize a taxable gain in an amount equal to the difference between your cost basis and the sales price. That realized gain is taxable, generally, as a “capital gain.”
However, there is a long-standing cost basis rule in the Internal Revenue Code that provides that when a person passes away, their beneficiaries inherit their (non-retirement account) assets with a “step-up” in cost basis. Stated another way, as a result of a decedent’s death, the decedent’s cost basis in an asset gets an automatic jump up to the asset’s fair market value, valued as of the decedent’s death. Thus, the decedent’s beneficiaries inherit the asset with a cost basis equal to the asset’s fair market value as of the decedent’s date of death. The significance of that is that any unrealized (or “built-in”) capital gain that may have gone unrealized during the decedent’s lifetime is wiped away at death. If that beneficiary holds on to the asset until his or her subsequent death, the assets would get an additional “step-up” in cost basis at that time and pass to a new set of beneficiaries without triggering any capital gain and, thus, without the payment of any tax on unrealized capital gains. The taxation of capital gains can continue to get deferred and then eliminated entirely in this manner. It is estimated that this “step-up in cost basis” rule saves taxpayers roughly $40 billion every year.
The changes to the taxation of capital gains under the AFP include the immediate realization of any capital gains in excess of $1 million upon a decedent’s death. Under the AFP, any capital gains on a decedent’s assets in excess of the $1 million exemption amount, would be taxed at a rate of 39.6%. The Treasury Department’s report states that this would go into effect for decedents dying after December 31, 2021.
Significantly, under current law, every individual has a $250,000 capital gain exemption on the sale of a primary residence ($500,000 for a married couple). This is commonly referred to as the “Personal Residence Exclusion.” The Personal Residence Exclusion means that, unless your primary residence has appreciated more than $250,000 since you bought it (or more than $500,000 for a married couple), you will not be taxed on the gain that is realized when you sell it. It is suggested that, under the AFP, this current exemption for the sale of a personal residence will remain in effect and be applied in addition to the $1 million gain exemption for all other assets.
Aside from the substantial capital gains tax that may be due, this taxation scheme could be problematic for an executor from purely an administration perspective. In order to comply with this new rule, if enacted, an executor of an estate would be tasked with determining the cost basis of all estate assets in the hands of a decedent, and then ensuring that such tax is paid by the estate. For assets that a decedent may have owned for several decades before his or her death, it could be very difficult to determine the purchase date and purchase price due to inadequate record-keeping or the transfer of assets from one financial institution to another.
For married couples, the proposed AFP allows a couple to shield combined capital gains of $2 million, plus $500,000 of gain on a primary residence. It is likely that, under the AFP, if the first spouse to die does not use all of his or her capital gain exemption amounts, the surviving spouse could take any unused portion and add such amount to his or her own capital gain exemptions at the time of his or her subsequent death. This would be consistent with the current federal estate tax “portability election,” which allows a surviving spouse to take any unused portion of a deceased spouse’s federal estate tax exemption, currently, $11.7 million, so that a married couple can shield $23.4 million from federal estate tax if a Federal Estate Tax Return (Form 706) is properly and timely filed.
Importantly, and (frankly) surprisingly, the AFP as currently proposed does not include any changes to the federal estate tax exemption passed under the Trump administration as part of the Tax Cuts and Jobs Act (“TCJA”) in 2017. Accordingly, as currently proposed, the $11.7 million per person estate tax exemption ($23.4 million for a married couple), as well as the 40% tax rate on assets that exceed such exemption amounts, would remain untouched. However, the TCJA has a built-in sunset provision, which reduces the estate tax exemption back to $5 million per person (indexed for inflation) on January 1, 2026. Of course, 2026 is still 4 ½ years away and it is certainly possible that the federal estate tax exemption could be changed under a revised form of the AFP or by future legislation.
With the AFP still only a proposal at this point, it remains to be seen how much of the plan will be enacted into law. However, if the proposed changes to the taxation of capital gains are passed, estate planning for many of our clients will take on a much different look and require substantially different considerations.
If you would like to discuss how the proposed changes to the federal capital gains tax laws may affect your specific estate plan, please call our office at 856-489-8388 or contact us here to schedule an appointment.