Client Login 401(K) Login Contact Us

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).

Current Law

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.

Proposed Law

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.

Summary

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.

Source: Whitehouse.gov

Jeffrey R. Lewis Jeffrey R. Lewis Financial Advisor

Jeff has been involved in the financial services industry since 2015. He earned a bachelor of science degree in economics from Illinois State University, graduating with cum laude honors.

About Savant Wealth Management

Savant Wealth Management is a leading independent, nationally recognized, fee-only firm serving clients for over 30 years with more than $10.1 billion in assets under management and assets under advisement (as of 3/31/2021). As a trusted advisor, Savant Wealth Management offers investment management, financial planning, retirement plan and family office services to financially established individuals and institutions. Savant also offers corporate accounting, tax preparation, payroll and consulting through its affiliate, Savant Tax & Consulting.

©2021 Savant Capital, LLC dba Savant Wealth Management. All rights reserved.

Savant Wealth Management (“Savant”) is an SEC registered investment adviser headquartered in Rockford, Illinois. Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments and/or investment strategies recommended and/or undertaken by Savant, or any non-investment related services, will be profitable, equal any historical performance levels, be suitable for your portfolio or individual situation, or prove successful. Please see our Important Disclosures.