The Taxpayer Repercussions of Eliminating the Step-Up Capital Gains Benefit
Despite likely pushback from Congress, the White House has taken aim at the "step-up" capital gains tax break. Financial planners should take note of the potential changes around capital gains taxes.
The White House and Congress have entered another round of bitter wrangling, this time over changes to the capital gains tax. As part of sweeping tax reforms proposed early this year, President Obama called for a few prominent capital gains modifications.
First, the administration seeks to eliminate the "step-up basis," a controversial loophole that shields the appreciated value of assets at the time of inheritance from the capital gains tax. The president is also pushing to raise the top capital gains rate to 28 percent for high-income households, and make death a taxable event.
In late March, the House Ways and Means Committee approved the "Death Tax Repeal Act of 2015," which (in opposition to the president's plans) would raise the capital gains threshold for heirs' sold assets from $1 million to $20 million.
Though each piece of proposed legislation is still in its infancy (with low odds of becoming law before the next election), financial planners should stay on top of these discussions in order to best prepare their clients for future income and estate tax scenarios.
Mulling the Effects of Capital Gains Tax Changes
Like most tax policy changes, removing the "step-up basis" has different ramifications depending on the taxpayer.
Currently, high-net-worth individuals with assets under $5.43 million ($10.86 million for couples) have little reason to pursue bypass trusts — which allow funds up to the grantor's estate tax exemption to bypass the spouse’s estate, thus forgoing the benefit of a second "step-up basis" — and can instead preserve more of their wealth through an estate. These individuals fall within the federal estate tax exemption, and the “step-up basis” ensures that their heirs are not burdened with a large capital gains tax.
If the “step-up basis” were struck down, the current tax paradigm would be turned on its head. Under the proposed changes, trusts may become an increasingly beneficial vehicle to preserve value. Trusts would no longer be disadvantaged with regard to capital gains dues, while offering significant savings by preventing the grantor's death from becoming a taxable event.
The proposed changes don’t just affect high-net-worth taxpayers, though. The White House’s capital gains reform would apply to all bequests and gifts, not just inheritances. While there is a provision that would allow taxpayers to exempt gains up to $100,000 ($200,000 for couples), the expanded definition of "realization events" compels middle-class individuals to track their assets more closely.
For wealth transfers that fall into the gap between the capital gains exemption ceiling and the estate tax floor (more than $100,000 but less than $5.43 million), there is no easy solution to avoid a 28 percent capital gains tax. Adding to the uncertainty, a wealth transfer over $5.43 million could cause the capital gains and estate taxes to stack, resulting in a taxation rate of up to 68 percent for heirs — even before calculating state liabilities.
Protecting Income, Regardless of Policy
Without a clear mandate, neither the White House nor Congress are likely to completely achieve their objectives, leaving the capital gains tax policy subject to political horse trading and additional revisions. At least for the near future, tax professionals will likely face a confusing set of guidelines governing their clients’ income and estate planning with regard to capital gains tax obligations.
Ambiguity around the tax burdens for high-net-worth and middle-class individuals makes for difficult financial planning, and strains tax and accounting advisors' resources. Income tax planning solutions can remove much of the uncertainty from the equation, and help tax professionals focus on identifying the best strategies for their clients.
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