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Capital Gains Taxation and Estate Planning

Written by: Bennie A. Wall

Posted on: November 6, 2020

Capital gains tax

Written by Bennie A. Wall, Esq. 

Last week I wrote to you with a blog covering potential changes to how estates and lifetime gifts are taxed in the future. If you missed it, check it out here: Wealth Transfer Strategies to Consider Ahead of the 2020 Election. Many of you have since asked about how capital gains taxes relate to estates and estate planning, so I thought I would take a few minutes to discuss capital gains and what changes may be on the horizon.

Current Rules

Since the passage of the American Taxpayer Relief Act in 2013, many commentators have described the capital gains tax as the “new estate tax” and this tax affects nearly everyone.

Without getting too deep into the weeds, capital gains are reported and taxed differently on the federal and state returns.

At the federal level, capital gains are taxed as ordinary income if those gains are realized on property held for less than one year (short-term capital gains). For gains on property held for a year or longer (long-term capital gains), there is a graduated tax rate depending upon the tax filer’s income level (0 percent, 15 percent, or 20 percent). For individuals and couples who earn more than $200,000 and $250,000 per year respectively in net investment income, there is an additional 3.8 percent surtax added to their capital gains tax rate.

At the state level, the Commonwealth taxes all capital gains reported on the federal return (whether short-term or long-term) as ordinary income with a top rate of 5.75% in 2020.

Calculating Capital Gains

To calculate your gain, you subtract your “basis” in the property (typically the price at which you acquired the item) from the amount realized (what you sold it for) and the difference is your gain or loss. For this reason, determining your basis in property is important.

Adjustments to Tax Basis

Current law allows for an adjustment in basis to the date-of-death value on appreciated property transferred after the owner dies. For instance, if you buy a share of Tesla stock for $30 and then sell it 10 years later for $3,000, then you will pay a tax on your long-term capital gain of $2,970. If, however, you hold on to that Tesla share with a $30 basis and leave it to your son when you die, then he takes the share with an adjusted, stepped-up basis set at it’s fair market value on your date of death. In other words, your son inherits it with a $3,000 basis and when he later sells it for $3,000 there is no capital gain and thus no tax owed on the proceeds.

Many families have taken advantage of these stepped-up basis rules by using like-kind exchanges. The laws governing like-kind exchanges on appreciated property, such as rental properties, allow people to reinvest the gains that they earn on appreciated property into similar types of property without ever having to pay capital gains taxes when sold.  If the individual keeps making such like-kind exchanges on appreciated property until the individual’s death, then the step-up in basis erases the capital gains that had accumulated in that property.

Carryover Tax Basis

In the context of estate planning with wealth transfers, it is important to examine the implications the transfer will have on tax basis. While bequests passing property that is otherwise included in the taxpayer’s gross estate receive the adjusted, stepped-up basis, gift made during the taxpayer’s lifetime do not. For gifts made during the taxpayer’s lifetime, the recipient receives the same basis as the original owner (i.e. carryover basis). Determining whether to give an asset during the lifetime of the client or to wait until the client passes away can, therefore, be a crucial consideration for an individual’s planning.

Possible Changes

Change may be on the horizon. Presidential candidate Biden has proposed changes that would either:

  • limit the adjusted basis rule for inherited property and impose a carryover basis rule for inherited property (e.g. rather than your heirs receiving the share of Tesla stock at $3,000 on your date of death, they would receive it with your carryover basis of $30); or
  • impose recognition of gain on property at the owner’s death (e.g. having your estate pay taxes on the $2,970 gains in your Tesla stock, even if the stock is transferred in kind to your heirs).

Other items proposed in Democratic tax plans are eliminating like-kind exchanges altogether as well as imposing a 39.6% long-term capital gains tax rate on individuals earning more than $1 million per year. If the law leaves the 3.8% surtax on net investment income in place, the effective top federal tax rate on long-term capital gains could reach over 43%–and that is before you add in Virginia’s top rate of 5.75%.

If Congress implements these changes along with the proposed changes to the estate tax exemptions and rates (see last week’s post, Wealth Transfer Strategies to Consider Ahead of the 2020 Election, for more information), many estates could see significant tax bills at the taxpayer’s death. While we cannot know for sure what the future holds, thoughtful estate planning can provide you with peace of mind knowing that you have done the best you can to make your wealth’s transfer as easy and as cost-effective as possible.

 

 

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