American Families Plan and Real Estate Investments–Stepped-up Basis

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Looking at this year’s list of Oscar nominees, I was drawn to the name of a live short nominee, “A Concerto is a Conversation,” because it was about the premiere of Kris Bowers’ violin concerto. Intrigued, I decided to watch the movie. Although this short didn’t win the Oscar, it’s still not to be missed.

From the title, I expected the film to be about Bowers, who, at 29, wrote the score for The Green Book. The LA Philharmonic’s premiere of Bower’s violin concerto “For A Younger Self” is the catalyst for the movie. But the movie is set up like a conversation between Kris Bowers and his 91-year-old grandfather, Horace Bowers, Sr., whom Kris Bowers says was “instrumental” in his success.

It is Horace, not Kris, who is the movie’s star. Born in Florida as one of 13 children, Horace Sr. left the Jim Crow South after graduating from high school. He started by hitchhiking and eventually made his way to Los Angeles, where pretending to be from an employment agency (but really representing himself), he found a job as a presser at a dry cleaner.

In just a few years, Horace met his wife, Alice, whose family was in the dry cleaning business. After marrying, they bought their own dry cleaning business in 1950.

Due to his race, Horace couldn’t get financing to expand his dry cleaning business. Ever resourceful, he got bank loans by mail. Because Horace was a successful business owner, he had no difficulty obtaining loans to buy real estate–as long as the loan officers didn’t know he was African-American.

By the 1960s, Horace and Alice owned an entire block of buildings on Central Avenue in South Los Angeles. And in 2019, the 2500 block of Central Avenue was dedicated as Bowers Retail Center.

Watching the movie, it’s evident that Horace and Alice overcame discrimination and built a family legacy through persistence, hard work, and ingenuity. Although he isn’t in the dry cleaning business, Kris is carrying on that legacy by breaking stereotypes in Hollywood and the classical music world.

I’m not familiar with Horace’s and Alice’s financial situation or estate plans, but it’s likely they also built a second type of family legacy–significant net worth. Many small business owners and real estate investors in their position would want to pass their financial legacy on to future generations. However, tax law changes in the American Families Plan could make it more difficult for middle-class Americans to build wealth and pass it on to the next generation

This article part of a series discussing how the American Families Plan might affect real estate investments. A previous article discussed how the American Families Plan proposes to change how long-term capital gains and carried interests are taxed. This article discusses lowering the estate and gift tax unified exemption and stepped-up basis.

Primer on Federal Estate Taxes

Estate taxes tax the transfer of property due to death. Property transfers are taxed whether they are in someone’s probate estate. Basically, everything a person owns, including “payable on death” accounts and certain trust assets not included in the probate estate, are part of the “gross estate.” Estate tax is based on the fair market value of the gross estate without considering the decedent’s purchase price, depreciation, amortization, or book value.

The gross estate is reduced by deductions for things like debts, funeral expenses, and estate administration costs to determine the “taxable estate.” But the entire “taxable estate” isn’t always taxed.

Under the unlimited marital deduction, property that goes to a surviving spouse isn’t taxed. Tax also isn’t paid on most charitable contributions made by an estate. Plus, in 2021, the first $11.7 million of the amount that’s left (after considering some lifetime gifts) isn’t taxed. This is called the “unified exemption” because the exemption applies to aggregated lifetime gifts and transfers due to death.

Plus, it’s possible to pass any unused exemption to the surviving spouse. So, if someone leaves their entire estate to their spouse or qualified charities, the surviving spouse might pass up to $23.4 million to the next generation without paying federal estate taxes.

The exemption hasn’t always been this high. In the 1970’s it was less than $150,000. That exemption gradually increased to $1 million in 2002. Then, in 2010, there was a big jump to $5 million. In 2017 there was a considerable increase in the exemption to $11.18 million, and it has increased gradually ever since.

With such a high estate tax exemption, few estates pay any tax. However, the 2017 estate tax exemption increase was temporary and is set to expire at the end of 2025. So, the exemption will drop to $5.6 million–admittedly still a high number, especially if spouses can combine their exemptions.

How the Stepped-Up Basis Works

Although the taxable estate is based upon fair market value at the time of death, the decedent’s “book value” for their business or real estate investment frequently is different (usually lower). Often, the decedent may have purchased their business or investment many years earlier at a lower price. The decedent’s book value also may have been reduced by depreciation or amortization deductions.

The question is whether the heirs “inherit” the decedent’s tax basis. Currently, heirs instead get a new stepped-up basis in property they inherit. That stepped-up basis is the fair market value at the time of death–the same value used to determine the taxable estate.

In theory, the estate pays taxes on the entire value of the decedent’s estate (minus exemptions). When estate tax has been paid on 100% of the real estate value, it makes sense to reset the heirs’ basis to match the value on which estate taxes were paid. If estate tax hasn’t been paid on real estate, the stepped-up basis admittedly doesn’t at first seem to make as much sense.

However, the stepped-up basis can benefit a small business like Horace’s and Alice’s dry cleaner. A business like that might entitle the heirs to a significant step up in basis. After, all the real estate and equipment likely have been fully depreciated over the years. And, the business probably has a high intangible value through the goodwill it has created through years of excellent service.

Unfortunately, most small businesses don’t have large amounts of cash sitting around. The owners either use the cash to support themselves and their families. Or they may invest the cash back into the business so it can grow. Without cash, the heirs cannot pay estate taxes–unless they sell the business to pay those taxes. For those heirs, the stepped-up basis allows them to maintain the family legacy.

How the Plan Would Change Estate Taxes and Stepped-Up Basis

The American Families Plan proposes many government benefits expected to help middle-class families. The plan also includes changes in the tax law. Tax increases are necessary to pay for coronavirus relief and to support post-pandemic social and infrastructure programs. However, some proposed tax law changes could make it more difficult for middle-class Americans to build wealth and pass it on to the next generation.

Although President Biden originally proposed reducing the unified exemption and eliminating the stepped-up basis. The American Families Plan doesn’t change the exemption, but it does eliminate the stepped-up basis for some estates. The plan retains the charitable donation exemption.

The American Families Plan proposes limiting the stepped-up basis to a $1 million increase over the decedent’s basis. The limit would be $2 mil for married couples. If the couple also had certain real estate gains, the limit might climb to $2.5 million. Family-owned businesses and farms would be exempt–but only if the heirs continued to run the business or farm.

Details about how the $1 million would be calculated aren’t clear. Also unclear is whether a family-owned business or farm would be exempt only if all of the heirs continued to run it. And it’s not clear how much work the heirs must do in the business or how long the heirs must run the business. If passed, the law and regulations will need to determine these critical details.

Still, as proposed, heirs of estates larger than the unified exemption ($11.7 million today and $5.6 million after 2025) will be double taxed under the American Families Plan. They will pay first pay estate taxes of as much as 40% of the estate above the exemption amount.

Then, despite having paid a hefty tax bill on that portion of the estate, the heirs will have a carried-over basis rather than a stepped-up basis. So, when the heirs sell their inherited asset, they will pay capital gains tax, which under the American Families Plan could be as much as 43.4% of the gain (39.6% for income taxes plus a 3.8% investment income tax under the Affordable Care Act). For an estate asset that goes to an heir who sells their investment, federal taxes could take up as much as 83.4% of their inheritance. And they also may have to pay state estate or income taxes. Although this would only happen when there is sizeable estate, the heirs of large estates aren’t necessarily wealthy. This high tax rate could affect heirs who are neither high net worth nor high income but have one year of high income when selling an inherited asset.

Policy Considerations and Multi-Generational Wealth

Tax policy serves both the purpose of raising funds for government programs and the purpose of shaping behavior. The social aspects of the American Families Plan are focused on inequities in opportunity. So, it’s no surprise that the economic aspects of the plan are focused on wealth inequality and on paying for coronavirus and social programs and reducing the national debt.

The American Families Plan also encourages the intergenerational transfer of family businesses and farms, which is part of the American Dream. But if the next generation’s skills or passions may lie elsewhere. Heirs who follow their passions instead of taking over the family business may find they own a big tax bill they wouldn’t have had if they stayed with the family business.

Horace and Alice built two types of wealth–economic wealth and wealth of character, evidenced by their hard work, ingenuity, and persistence in the face of discrimination. Although Kris may not (yet) have inherited Horace’s and Alice’s economic wealth, their wealth of character is evident in Kris’ work and success in an industry that historically hasn’t welcomed African Americans.

As proposed, the American Families Plan would incentivize high net worth individuals to limit intergenerational wealth transfers. It also might encourage them to make more charitable contributions. However, by limiting intergenerational transfers of economic wealth people, people may change their estate planning. Instead of transferring significant financial wealth to the next generation, they might focus on charitable giving and leaving the next generation a nontangible inheritance of character and charitable giving.

This series draws from Elizabeth Whitman’s background in and passion for classical music to illustrate creative solutions for legal challenges experienced by businesses and real estate investors.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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