There is an election looming over the horizon, and the outcome could have a significant impact on the federal estate tax parameters. High net worth individuals may be negatively impacted by a shift in the political mindset. Let’s look at the details.
Federal Estate Tax Exclusion
The majority of taxpayers do not have to worry about paying the federal estate tax, because you can transfer a certain amount before the tax would be levied. This threshold is called the estate tax credit or exclusion. When a piece of tax legislation was passed in 2017 for the 2018 calendar year, it had an impact on this exclusion.
In 2017, the exclusion was $5.49 million, but was essentially doubled to $11.18 million for 2018. Since that time, there have been annual adjustments to account for inflation. At the time of this writing in 2020, the exact amount of the federal estate tax exclusion is $11.58 million.
You don’t have to worry about paying an estate tax on transfers to your spouse, because there is an unlimited marital deduction. It should be noted that this is only available to American citizens.
Some Democratic presidential candidates floated the idea of a “wealth tax” on the richest Americans. Joe Biden was not one of them, but he could try to champion a reduction in the estate tax exclusion.
This would expose more wealth to taxation, and the tax would reach more families. The likelihood of a change like this being implemented would increase exponentially if the Democrats were to win a Senate majority.
Capital Gains Tax and the Step-Up in Basis
You have to pay the capital gains tax when you realize a gain, which is the act of selling an appreciated asset. If you realize a gain less than a year after the original purchase of the asset, you pay a short-term capital gains tax at your regular income tax rate.
Gains that are realized more than a year after the original acquisition are long-term capital gains.
If you claim less than $40,000 a year on your return, there would be no long-term capital gains tax. The rate is 15 percent for people that earn between $40,000 and $441,450, and it is 20 percent for the highest income earners.
The best way to explain the step-up in basis is through the utilization of a hypothetical scenario. For the purposes of this example, we will say that you inherited 2000 shares of stock from your grandmother. The original purchase price was $10 a share, but after 30 years, it went up to $50 a share.
She paid $20,000 for the stock, but it is now worth $100,000. If your grandmother sold the stock while she was living, she would have been required to pay the long-term capital gains tax on the $80,000 appreciation.
You on the other hand would get a step-up in basis. For capital gains purposes, the present value of your stock would be $100,000, so no taxes would be due. However, if you maintain possession of the stock and sell it later after it goes up in value, you would be responsible for those gains.
Presumptive presidential nominee Joe Biden has a specific platform position on this subject. He would do away with the step-up in basis entirely. A lot of wealthy people use the step-up in basis to transfer wealth in a tax-free manner, so this would be a big change.
It should be noted that the president cannot wave a magic wand to alter the tax laws, because budgets are ultimately set by Congress. However, this is definitely a possibility, especially if the Democrats maintain their majority in the House and seize the majority in the Senate.
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