Personal Finance

This is how Joe Biden will tax generational wealth transfer

Key Points
  • Under current law, assets that pass directly to heirs benefit from a step-up in basis. This means the heir receives the asset valued as of the date of death.
  • If the heir sells this holding right away, he pays little to no capital gains taxes.
  • Biden’s proposal would tax an asset’s unrealized appreciation at transfer, according to the Tax Policy Center.
Democratic presidential candidate former Vice President Joe Biden reacts while giving a speech during a campaign event at Tougaloo College on March 08, 2020 in Tougaloo, Mississippi.
Jonathan Bachman | Getty Images

Former vice president Joe Biden's $4 trillion tax plan would raises taxes on higher income households both in life and at death, according to analysis by the Tax Policy Center.

The Democratic presidential contender proposed a raft of tax policy changes that would raise levies on the wealthy, including boosting individual income tax rates on households with taxable income over $400,000, according to the center's study.

Biden has also set his sights on estates, but is taking a different tack from merely raising rates on wealth transfer.

He would levy a tax on unrealized appreciation of assets passed on at death, the center found.

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The move does away with a tax-planning tactic known as the "step-up in basis," which allows heirs to minimize taxes when they sell holdings they've inherited.

"When someone dies and the asset transfers to an heir, that transfer itself will be a taxable event, and the estate is required to pay taxes on the gains as if they sold the asset," said Howard Gleckman, senior fellow in the Urban-Brookings Tax Policy Center.

Here's what it might mean for you.

Step-up in basis

Oliver Rossi

Currently, it's a pain-free time to transfer wealth.

The Tax Cuts and Jobs Act roughly doubled the amount that you can give away to others without being subject to the 40% estate and gift tax.

This so-called estate and gift tax exemption is $11.58 million per individual in 2020.

But the tax provision wealthy households hold most dear is a decades' old corner of the tax code known as the "step-up in basis."

In this case, an individual holds an asset for many years, watches it appreciate and passes it to an heir at death. The basis — the owner's original investment in the asset — rises to the market value as of the date of death and the heir inherits this "stepped-up basis."

If the heir turns around and sells the asset, he can do so with little to no capital gains tax.

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"It's an enormous loophole in the law, the step-up in basis," said Jonathan Blattmachr, estate attorney and principal at InterActive Legal. "You get the step-up in basis even if you don't pay the estate tax."

By taxing the unrealized gain at death, heirs would get hit at the transfer, regardless of whether they sell the asset, Gleckman said.

The capital gains tax bite under the former vice president's plan would also be harsher than it is now.

Under the current framework, the long-term capital gains tax rate is 20% for single households with more than $441,451 in taxable income ($496,601 for married-filing-jointly) in 2020.

Biden's proposal would increase capital gains taxes by subjecting gains to the same tax rate as ordinary income for households earning more than $1 million.

He would also do away with the current top ordinary income tax rate of 37%, bumping it to 39.6%.

Finally, you can't avoid the tax hit by merely gifting the asset to another person while you're alive. The appreciation would still be subject to taxes upon transfer under Biden's proposal, Gleckman said.

Planning around it

wundervisuals | E+ | Getty Images

Bear in mind that a tax overhaul like this one would need Congressional approval to proceed, so nothing is set in stone.

There's also still uncertainty on how the tax would ultimately look if it were implemented under a Biden administration.

"Is the death the realization event, or does the next generation receive assets that don't have a step-up in basis?" asked John Voltaggio, managing director at Northern Trust. "Either way, it's more of a tax on the next generation."

But if this tax on unrealized gains came to pass, people will need to rethink the way they manage their investments and their estate plans.

"People have been passing on less-than-perfect portfolios because they're waiting for the step-up in basis," said Robert S. Keebler, CPA and partner at Keebler & Associates in Green Bay, Wisconsin.

Those investors might be willing to diversify and sell out of concentrated positions or rebuild an entire portfolio.

"Many people have over half of their net worth in one hand-me-down," Keebler said.

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Investors may also be less inclined to chase riskier assets with higher rates of return.

"It might cause people at higher tax rates to invest more conservatively," said certified financial planner Jamie Hopkins, director of retirement research at Carson Group. "Money might move toward more long-term companies and companies paying dividends."

Families may also be more interested in donating to their favorite causes.

"You have this low basis asset that won't get the step up, so you might be more inclined to give to the charity," said Voltaggio.

Finally, life insurance could also take center stage for those who want a tax-friendly way to pass on wealth.

"The biggest opportunity to avoid the tax is the exception for life insurance proceeds," Blattmachr said. "Life insurance proceeds aren't includible in the recipient's gross income."