The new tax plan recently announced by the politicians has caught my eye with one thing in particular – the repeal of the estate tax.
Most people think that the estate tax doesn’t affect them. With the $5.49M exemption per person, most people won’t have enough assets at the time of their deaths to actually pay the tax.
However, that’s not the only effect the tax has on estate beneficiaries. And repealing it will not only help the rich save on the tax payments, but will also increase the tax burden on the middle-class families that inherit assets from their parents.
How? Three words: stepped up basis. Which will disappear together with the estate tax itself.
Stepped-up basis is a term applied to the reassessed acquisition value of assets for tax purposes when these assets are passed to estate beneficiaries. What it means is that the beneficiaries will use the fair market value at the time of the benefactor’s death as their basis in the assets for tax purposes, instead of the original acquisition costs of the benefactor. Why is that allowed? Because the benefactor’s estate paid the estate tax on the difference between the original acquisition costs of the benefactor and the fair market value at the time of the death. In most cases, no actual tax is paid because of the exemption, but the fact that the estate went through tax assessment is enough to justify the basis step-up, even if no actual tax was paid because the total taxable amount was below the exemption.
This way, the middle class families can accumulate wealth and pass assets to the next generation without being hit with the expensive tax bill when the heirs sell the properties.
However, if the estate tax is repealed, so will be the stepped-up basis rules. For the wealthy – that would be a saving: the estate tax rate above the exemption is 40%, while the capital gains tax on the difference between the sale proceeds and the acquisition costs is less than 25%.
For the middle class that doesn’t get to pay the actual estate tax? The 25% tax increase on the price difference that was essentially tax-free before due to the estate tax $5.49M exemption. This can amount to more than a million of dollars in extra taxes!
Let’s see an example:
John Doe Sr. bought a house in 1950 for $20,000.
John Doe Sr. passed away in 2017 when the house was valued at $500,000. The 480,000 difference went through the estate tax assessment, and the new basis for the John Doe Jr., and Jane Doe the beneficiaries, is $500,000. The estate paid no tax on the $480,000 gain since it is below the $5.49M exemption
John Doe Jr. and Jane Doe then sell the house to split the proceeds and improve their lives, and only pay capital gains on the proceeds above the $500,00 value of the stepped-up bases.
Had there been no estate tax, John Doe Jr. and Jane Doe would have to pay capital gains tax on the whole $480,000. At 25% (proposed) rate that would be a $120,000 tax bill.
For the middle-class Does the repeal would cost extra $120,000 in taxes.
Now, consider how this affects the wealthy:
John Smith Sr. bought a company for $20M in 1950. By the time of his passing in 2017 the very successful company was worth $500M. The $480M difference is taxed at the 40% rate of the estate tax, and the estate pays $192M in taxes.
John Smith Jr. and Jane Smith then sell the company to pay for their lavish lifestyles and only pay the capital gains tax on the proceeds above the $308M (the estate paid $192M in taxes).
Had there been no estate tax, John Smith Jr. and Jane Smith would have to pay capital gains tax on the whole $480M. At 25% (proposed) capital gains tax, they’d pay $120M, keeping $380M (as opposed to $308M with the estate tax scenario above)
For the wealthy Smiths, the repeal would save $72M in taxes.
Still think this doesn’t affect middle-class Americans?
Your Little Advisor.