How Could the American Families Plan Impact the Taxation of Your Vacation Home?
My last post, Dynamics of Purchasing a Vacation Home in Retirement, focused on factors to consider when you structure ownership of your second home if you wanted to leave the property to your children or grandchildren after you pass away.
With the proposed American Families Plan in the headlines, there are many questions about the potential tax liability of these properties in the event the proposed bill is signed into law. It’s important to remember that the American Families Plan is just a proposal, but it doesn’t hurt to consider the potential effects of the new law if it is passed.
How are second, third, or fourth properties taxed under current law when inherited?
Currently, if you inherit a capital asset (i.e. second home) that increased in value when the person who died owned it, the asset’s cost basis (i.e. purchase price) is increased to the property’s fair market value at the date of the previous owner’s death. This adjustment is called a “step-up” in basis (or “stepped-up” basis). The increase in basis also means that the person who inherits the property can sell it immediately without paying any capital gains tax, essentially wiping away any potential tax implications.
How is the step-up in basis impacted by the American Families Plan?
While the American Families Plan doesn’t provide many details, the plan calls for an end to the effects of a stepped-up basis for unrealized (assets that have not been sold) capital gains of $1 million or more ($2 million or more for a married couple). This would hypothetically apply to all capital assets (second properties, investment properties, stocks, bonds, pieces of art, etc.) with a gain in excess of $1 million ($2 million for couples).
Increased Capital Gains Tax Rate for Highest Earners
Elimination of the step-up in basis could be amplified if the president’s proposal to raise the top tax rate on long-term capital gains is also enacted. Under the American Families Plan, the highest tax rate on long-term capital gains would shoot up from 20% to 39.6% for people earning $1 million or more for the year. Also, don’t forget about the 3.8% Medicare surtax that applies to net investment income as well, this would hypothetically bring the top tax rate from 23.8% to 43.4%.
Application of the Numbers: Hypothetical Example of the Current Law vs. Proposed Law
Jane Doe is retired and was a good, disciplined saver over her life and has accumulated a nice nest egg for herself ($3 million). She owns a second property in Florida that she bought 30 years ago for $400,000 (cost basis), now valued at $1,000,000 (unrealized gain + $600,000). She also has a Trust account that has appreciated over time and is now worth $2,000,000 (cost basis = $1,000,000; unrealized gain = $1,000,000). Her total unrealized capital gain is $1.6 million ($600,000 + $1,000,000).
At death, both the Trust account and the Florida property would receive a step-up in basis to the fair market value (FMV) at date of death.
Trust Account: (FMV $2,000,000) – (Stepped-up basis $2,000,000) = $0 capital gain
Florida Home: (FMV $1,000,000) – (Stepped-up basis $1,000,000) = $0 capital gain
Assuming the heirs sell everything once they receive the inheritance, they will not owe any income tax upon Jane’s death.
At death, the first $1 million of capital gains would not be subject to capital gains tax. However, any capital gain amount exceeding that threshold would be subject to the standard 0%, 15%, 20% (or proposed 39.6% for individuals making over $1 million or more) capital gains tax rate.
Trust Account: (FMV $2,000,000) – (stepped-up basis $2,000,000) = $0 capital gain.
Florida Home: (FMV $1,000,000) – (basis of $400,000) = $600,000 capital gain.
$600,000 x 0.15% = $90,000 capital gains tax upon Jane’s death.
Notice the Florida home did not receive a step-up in basis due to the Trust account using the full $1 million exclusion under the proposed law. This results in a $90,000 tax bill for Jane’s heirs upon her death, even if they do not sell the property.
At this point, there are many details that still need to be ironed out in Congress and if history tells us anything, that could take a while. However, it is not a bad idea to start thinking about your overall estate plan and how potential tax changes could impact you or your heirs. Talking things over with your financial advisor about your specific situation is a crucial part of proper estate and tax planning. More to come throughout 2021.