Owners, Heirs Face Threats to Step-Up Basis

So Far, Legislators Haven’t Touched This Important Provision, but it’s Critical to Continue Defending Tax Rules That Enable a Step Up to Fair-Market Value at Inheritance.

Owners of commercial property and real estate investors have found 2021 to be perplexing and frustrating. Not only has the pandemic continued to hammer values and cloud the outlook for recovery, but some in Washington continue to push proposals that could mightily increase taxes on owners of appreciated capital assets. The bipartisan infrastructure bill signed by President Joe Biden Nov. 8 didn’t include these troublesome provisions, but it’s good to be aware of these ideas because they’re likely to resurface.

Tax increase ideas are nothing new, but with a social safety net bill on the docket and needing funding, we can’t ignore the possibility that property owners may have to soon pony up more to Uncle Sam. Along with other potential increases, recommendations exist that would change the tax treatment for those who bequeath and inherit property. Let’s look at how such transfers are treated in the law today compared with proposals that would drastically change the rules

How the Current Law Works

Property owners who hand down assets to their heirs are not taxed on the appreciation in the property’s value during their lifetime, and those who receive the assets are given a step up (or step down) in the tax basis of the property to its fair market value generally as of the date of the decedent’s death. This is widely known as “step-up” and has been a staple of our tax system for over a century.

Example 1: Jim dies owning land he purchased for $30,000 in 1971 and leaves it to his niece, Sophia. The FMV of the land on the date of Jim’s death was $500,000. Had Jim sold it before he died, the sale would have generated a capital gain of $470,000. The gain would have been taxed at a rate as high as 23.8% (including the net investment income tax). However, Sophia receives a step-up in the tax basis of the property to $500,000, so she will pay tax only on any future appreciation and only if and when she sells it.

Proposal to Switch Tax Basis from Stepped-Up to Substituted

For years, opponents of this current treatment have flailed it as a loophole for the wealthy that must be closed to make the U.S. tax system fairer. Their solution has been to switch heirs from a stepped-up to a substituted tax basis, usually the price paid by the decedent. In this way, when and if inheritors decide to sell, they would have to pay tax on any value increase from the time their benefactor purchased the property. However, lawmakers are pondering concerns ranging from the forced sales of family businesses and farms to pay the tax to the difficulty of determining how much Granddad paid for the property.

Example 2: In the example above, let’s say substituted basis has replaced stepped-up basis. Instead of being $500,000, Sophia’s tax basis would be just $30,000, the same as Uncle Jim’s. Suppose two years after she inherits the property, she sells it for $530,000. Rather than a capital gain of $30,000, she would face a gain of $500,000. Thus, Sophia’s tax would be many multiples of what she would owe under current law.

White House Proposal

This spring, a new proposal emerged, and President Joe Biden endorsed it to help offset the cost of his legislative priorities. This plan would tax decedents’ estates on any unrealized capital gains that exceeded $1 million per person. This would be true even if the heir did not sell. Thus, the Treasury’s take would come faster and not depend on the inheritor’s cashing in on the property.

Example 3: Let’s say, at death, Uncle Jim also owned stocks and bonds valued at $1.5 million, for which he paid $500,000. Including the land he leaves to Sophia, Jim’s total amount of unrealized gain is $1.47 million. The excess over the $1 million exemption, or $470,000, would be taxed to Jim’s estate as a capital gain.

Mark-to-Market Proposal

Going well beyond even the president’s proposal, Sen. Ron Wyden (D-Ore.) put forward an idea to tax increases in the value of capital assets even before the owner dies and regardless of whether the assets are sold. This concept, known as “mark to market,” would require those with more than $1 million in annual income or $10 million in assets to pay capital gains tax annually on any net increase in the assets’ value.

Example 4: Let’s say Jim meets the income or asset test of the Wyden proposal. He would have to pay tax on the net increase in the value of his tradable capital assets each year of his life. For non-tradable assets like real estate, tax due on the gain each year would be determined by a look-back charge once the property was sold or bequeathed.

Where the Proposals Stand

NAR and other groups have vigorously opposed these changes, and this advocacy appears to have been effective. None of the three proposals made it into the infrastructure legislation and, so far, none has been added to other bills moving through Congress. Still, it’s too early to rule them out entirely. And even if property owners dodge a bullet on attacks to the step-up basis this year, you can be sure these tax increase ideas are not going away.

Sources NAR.COM/EvanLiddiard