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A Step-Up in Basis, The American Families Plan

Updated: Nov 12, 2021

A tax advantage that has benefitted many Americans over the years has been proposed to be eliminated. President Biden’s The American Families Plan is proposing to eliminate the “step-up” in basis, among other items. Combined with a proposed increase to capital gains from 20% to 39.6%, the effect is an estate tax on estates that currently are valued beneath the federal estate tax exemption of $11.7 million.

Basis is effectively the “cost” of an asset. Basis can be adjusted up or down, based on how many after tax dollars are put towards the asset. Think of a home. When the home is purchased for $250,000, the basis for that home is $250,000. This is the amount that the selling price will be measured against to determine capital gains. If the homeowner is able to sell their home in the future for $325,000, for example, then the homeowner will have generated $75,000 in capital gains ($325 - $250). If, while the homeowner still owned the home, the homeowner made improvements to the home, such as an addition or kitchen renovation that cost $25,000, that $25,000 is added to the basis. The homeowner now has an adjusted basis of $275,000. If she is still able to sell in the future for $325,000, her capital gains has shrunk to $50,000 because of the increase to basis.

The “step-up” in basis occurs when the owner of assets dies, and the assets pass to her heirs. When assets are transferred due to death, the basis of the asset is stepped-up to the Fair Market Value (FMV) of the asset. So back to the home example. Instead of selling the home, the homeowner holds the house until her death, and then transfers the house to her niece upon her death. The homeowner’s basis was $250,000, because that is what she spent on the house. The niece, who now takes the house upon the homeowner’s death, will have a basis of $325,000, assuming that is the FMV. The benefit is to the recipient of the property because the step-up just allowed her to avoid $75,000 in capital gains taxes. When the niece goes to sell the house in the future, her capital gains will be measured against $325,000, not $250,000. If she sells for $325,000, then her capital gains will be $0 because the selling price equaled her adjusted basis.

The step-up in basis only occurs for gifts that happen at death, not for gifts during the asset holder’s life. Continuing with the home example, if the homeowner were to gift the house to her niece while the homeowner was still living, the recipient, the niece, would assume the gift-giver’s basis. Even though the home may have a FMV of $325,000 at the time of transfer, if the transfer happens while the homeowner is still alive, the recipient’s basis will be the same as the homeowner’s - $250,000 in this example.

With the current step-up in basis, the recipient avoids tax on capital gains that stem from the difference between the FMV of the asset and the decedent’s basis. Eliminating this function adds a tax liability to the recipients. The American Families Plan does provide for an exemption of $1 million, though. That exemption will likely protect many middle-class homeowners, as most homes will not appreciate by $1 million or more. So who is at risk? Primarily family farms and small family businesses are who will be hurt by this proposal.

Let’s look at a family farm example. It is not unreasonable to imagine a small farm purchased in the 1970’s or 80’s for say $300,000, now being worth in excess of $1 million. For illustrative purposes, let’s say that farm purchased for $300,000 now has a FMV of $1.5 million. Under the American Families Plan proposal, when the farmer dies and leaves the farm to his heirs, the heirs will be faced with $200,000 in capital gains, should they decide to sell the farm right away. The $200,000 is calculated by taking the FMV of $1.5 million less the farmer’s basis of $300,000, which leaves $1.2 million. The proposal allows for a $1 million dollar exemption, so subtracting that from the $1.2 million, the farmer’s heirs have a capital gains potential of $200,000. Again, under current law, there would be no capital gains, as the basis would be stepped all the way up to the FMV.

Note that capital gains only apply when the asset is sold. The FMV can, and likely will, fluctuate over time. No tax is due until the asset is actually disposed of.

Though somewhat simplified, these illustrations are intended to show what is at risk under the proposed legislation, and to highlight the importance of estate and tax planning. Call Doug Peterson to schedule a consultation to review your estate plans, and the potential tax implications.

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