President Joe Biden has proposed substantial changes to the tax code, mainly focused on individual income and investment taxes, and at least some of them stand to have a significant impact on high-net-worth investors. The proposed changes create challenges, but also planning opportunities. This blog post focuses on what potential changes are ahead, who would be impacted, and how you can prepare. The key planning take-aways are:
- For those earning over $1M in income and considering selling an appreciated asset in the next 12 months, we’d strongly encourage selling that asset within 2021 to avoid the proposed higher tax rates.
- If the increased capital gains rates pass, consider ‘gains smoothing’ to avoid recognizing all your capital gains in one year where it may push your income over the $1M threshold.
- Estate tax limits are set to come down in 2026, if not sooner, so best to take action now if your estate value significantly exceeds the current estate tax limits.
- For those who think they will be in a higher tax bracket during retirement than they are today, 2021 may be a good time to consider a Roth conversion.
WHAT ARE THE PROPOSED TAX CHANGES BY BIDEN?
Consistent with his campaign promises, President Joe Biden announced in late April the ‘American Families Plan’ which calls for substantial tax reform. The Treasury Department also released its much anticipated ‘Green Book’ at the end of May, which summarizes the Administration’s tax proposals contained in the budget. While the proposal includes some dramatic tax increases, it’s important to remember we are still very early in the legislative process and these are just proposals at this point. We are in the long process of reaching compromise, as each of the proposals will have to be passed by Congress. While nothing is certain, there are themes emerging that provide insight into the changes that might be coming and are important considerations for our future planning. Here is a high-level summary of what Biden has proposed:
- Increase Federal Tax Rates: Increase the top income tax bracket from 37% to 39.6%. This is a 7% increase in taxes, but it will only impact the highest earners, defined as those earning more than $400K.
- Increase Corporate Tax Rate: Increase the corporate tax rate from 21% to 28%. This is a 33% increase! Corporations previously received a big tax cut under President Trump and this proposal would essentially reverse that.
- Increase Capital Gains Tax Rates: The top capital gains rate would double from 20% to 39.6% – almost a 100% increase! (and this does not include the net investment income tax of 3.8%, which will remain). This will only apply to those with over $1M of income – the top 0.3% of taxpayers.
- Limit Cost Basis Adjustment at Death: Under current law, the cost basis of a person’s assets are reset at their passing, making any unrealized gains up to that point free of capital gains taxes. What is being proposed is a $1M ceiling on this capital gains adjustment. Gains in excess of $1M would either be taxable at the person’s passing or would simply have their original cost basis carried forward to the new owner.
- Limit tax-free exchanges of investment real estate: Limit 1031 exchanges to $500K of gain per person ($1M for married filing jointly)
- Increase Frequency of IRS Audits: The administration plans to allocate more resources to the IRS to increase tax audits of households with more than $400,000 in income.
WHO WILL THESE TAX INCREASES IMPACT?
President Biden has repeatedly stated that he’s not going to raise taxes on taxpayers making less than $400,000 per year. But there are rare instances — primarily concerning one-time windfalls like the sale of an appreciated home, business or other asset — that may test the “spirit” of Biden’s pledge. The newly proposed capital gains tax rate could impact taxpayers who don’t annually earn anywhere near $1M but do have a once-in-a-lifetime taxable event that can temporarily push their income over the $1M mark.
Those who have the most opportunity to avoid this tax are individuals or families who:
- Earn over $1M in income
- Hold highly appreciated assets
- Hold large pieces of real estate
- Are an individual potentially within 5 years of death with appreciated assets
For anyone earning over $1M a year who is considering selling a highly appreciated asset (stock or real estate), this is a clear benefit to executing that sale within 2021.
Finally, the reduction of the ‘step-up’ in basis would mean that death would be treated as a “realization” event. Assets with more than $1M of appreciation would be treated as if sold — and subject to capital gains tax. Currently, appreciated assets aren’t subject to a capital gains tax at death. Heirs receive stock, homes and other assets at current market value and pay tax only on subsequent gains if and when they sell. The first $1M for single taxpayers ($2M for married couples) would be excluded from Biden’s tax on unrealized capital gains. Single and married taxpayers could exclude an additional $250,000 and $500,000 of gains, respectively, for a principal residence.
HOW LIKELY IS IT THAT THIS LEGISLATION WILL PASS?
We believe it’s hard timing markets and even harder timing Washington D.C. Dan Clifton, Head of Policy Research at Strategas Research Partners and our connection to what is happening on the Hill, has shared the following insights:
Dan expects that the top income tax rate will increase from 37% to 39.6%, the capital gains rate will increase from 20% to 28%, and the corporate tax rate will increase from 21% to 25%. He expects to see an increase in the State and Local Tax Deduction (SALT) as this is important to moderate Democrats in higher income districts.
On estate taxes, he predicts that the estate tax rates will increase, and the exemption amount will be lowered. Note this is very different than what Biden proposed. Biden has proposed moving from a step up in basis to a carryover basis and impose a new unrealized capital gains tax at death for gains over $1M. Both ideas are not getting the traction needed to pass in a narrowly divided Congress.
While Biden’s budget proposal assumed that these taxes would be retroactive to April 2021, Dan believes that any new tax legislation is unlikely to be finalized until very late in 2021, making it improbable that the new rates would be applicable for the current year. That being said, taxes being applied retroactively is not without precedent and could be pursued more aggressively given a sufficient revenue shortfall.
AREN’T TAXES ALREADY SET TO INCREASE IN 2025?
Yes. December 31, 2025 will be a significant day for most taxpayers. Twenty-three provisions from the 2018 Tax Cuts and Jobs Act (TCJA) directly relating to individual income taxes will expire, meaning most taxpayers will see a tax hike unless the provisions are extended. The individual income tax code is effectively scheduled to return to what it was before the TCJA, meaning personal exemptions, the overall limitation on itemized deductions, uncapped state and local tax deductions, and many other miscellaneous itemized deductions will return.
There were a few permanent tax changes included in TCJA that will not expire at the end of 2025 (unless otherwise approved by Congress), such as:
- No deductions for alimony payments required by post-2019 divorce agreements.
- No more reversals of Roth IRA conversions.
- Tax-free distributions of up to $10,000 annually from Section 529 accounts to cover qualified K-12 school expenses at public, private or religious schools.
- Flat 21% federal income tax rate on corporations (Biden has also proposed to increase the corporate tax rate to 28% now)
WHAT STRATEGIES MAKE SENSE TO AVOID THESE POTENTIAL TAX INCREASES?
Increased Income Tax Rates: If you anticipate income in future years being over $400k, it might make sense to consider an IRA distribution or Roth conversion to realize income at the current rates. If you are a business owner, you may consider speaking with your accountant about accelerating billing and income recognition to the lower tax year and/or postponing certain expenses to higher tax-rate years.
Capital Gain Tax Rates: If you are anticipating withdrawing funds or recognizing gains in the next few years, you may consider accelerating capital gains when possible. We are not recommending wholesale liquidations of appreciated assets, but if you know capital gains on current assets will need to be recognized in 2022, it may be worthwhile accelerating some of these gains to 2021 under the lower, known long-term tax rates. If the legislation for higher capital gains rates passes, we anticipate installment sales of businesses or property may become more popular to help keep annual income under $1M.
Gain Smoothing: Another strategy to avoid higher capital gains tax rates is to plan carefully around the proposed $1M income threshold. With thoughtful planning, a taxpayer can try to target keeping their gains and overall income under the $1M threshold in any given year.
Closely-held Businesses: Business owners who are considering the potential sale and exit of a business – that may potentially have a ‘lifetime’ of growth all taxed in a single year of sale – will seriously want to consider liquidating the business before year-end.
Estate Planning: For individuals with highly appreciated assets, some of the benefits of holding these positions until death may evaporate under the proposed legislation. If there are positions being held in your portfolio purely in anticipation of the cost-basis step-up, it will be important to revisit these decisions. For those with estates well in excess of the current Federal Estate Tax exemption, there may be opportunities to utilize the current exemption levels via lifetime gifting before they are reduced to their pre-TCJA levels.
WHAT DO WE SEE GOING FORWARD?
All of these proposals are subject to the complex legislative process. Biden’s narrowest-possible margin in the Senate means that any proposal will have to gain approval from all 50 Democratic senators for Vice President Harris to have a shot at casting the tiebreaking vote.
Stay tuned for more updates. We will continue to monitor changes as the situation evolves. In the meantime, we are planning for higher taxes ahead. As always, please contact your advisory team to discuss the best possible strategies for you.
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