Here’s how capital gains tax changes could impact your clients’ estate planning for 2022
Estate planning is often treated as a “set-it-and-forget-it” topic, but it is vital—especially for wealthy clients—to stay on top of changes in law and in assets because failing to account for current tax law can put your heir’s inheritance at risk of significant reduction. Proposed capital gains tax changes will dramatically shift thresholds, making it more vital than ever for financial advisors to help their clients keep estate plans current and comprehensive.
Historically, the step-up basis has been one of the strongest strategies for wealthy individuals to avoid paying capital gains taxes at death, but proposed changes to tax law could eliminate this rule. The step-up basis allows clients to leave large assets—such as stocks, real estate, and other capital assets—to their heirs without having to pay capital gains tax, as the assessed value of the asset is automatically “stepped-up” to the current market value.
Without the step-up basis, heirs may have to pay capital gains tax on the increase in value between the decedent’s purchase and their death—sometimes meaning decades of value appreciation. Here’s how financial advisors can help their clients prepare for this possible change.
What proposed changes to the capital gains tax affect estate planning?
The new tax laws proposed in April 2021 would eliminate the step-up exemption on any inherited asset that has gained more than $1 million in value between purchase and death. In his April 28th, 2021 speech introducing the proposal, President Biden explained, “Ending the practice of ‘stepping up’ the basis for gains in excess of $1 million ($2.5 million per couple) and making sure the gains are taxed if the property is not donated to charity.”
In 2021, the estate and gift tax exemption of $11.7 million ($23.4 million for married couples) will still allow your clients to pass on up to that amount before paying any estate tax, but any assets rising above that threshold are at risk of double taxation (estate tax and capital gains tax) without the step-up exemption. Additionally, there has been a proposed increase to the capital gains tax, from 29% to almost 49% if including top state and federal tax.
‘The new tax laws… would eliminate the step-up exemption on any inherited asset that has gained more than $1 million in value between purchase and death.’
Let’s use a house, for example:
Under the current rules, if a house is purchased at $1 million and rises in value to $5 million at the time of the owner’s death, the asset basis is “stepped-up” to $5 million upon inheritance, and the heir pays no capital gains tax.
Under the proposed rule, for the same house, the asset basis remains at $1 million, and the heir is liable for capital gains tax on the $4 million value that the home has appreciated since purchase. In combination with the proposed increase to capital gains tax, this would mean the heir would have to pay about $1.96 million just to keep the house.
Who would see the biggest impact of these changes?
This will have an outsized impact on the estates of the ultra-wealthy, as they are likely to own many assets that will fall into the new category and will likely exceed the estate and gift tax exemption. Previously, the step-up basis was a solid way to avoid capital gains tax on stocks by placing these holdings into a trust fund for an heir, but this strategy wouldn’t work under the new law.
‘Paying a large capital gains tax could force children to sell a family home.’
However, this change can also impact a wider range of clients, not just ultra-high net worth individuals. With booming housing markets, especially in large metropolitan areas like San Francisco and New York, many people may own homes that have significantly appreciated in value. Paying a large capital gains tax could force children to sell a family home that they would rather use as a residence.
How capital gains tax can be avoided on large assets
Under the proposed law, there would be only two ways to avoid paying capital gains tax entirely. Family businesses and farms that are passed on in an estate would be exempt if the heir continues to run them. Donating assets to charity will also continue to be a strategy to avoid paying capital gains tax on those assets, so charitable trusts will remain an important strategy in estate planning.
‘This legislation may make it advisable to consider transferring property prior to death.’
Otherwise, this legislation may make it advisable to consider transferring property prior to death, especially family homes, and utilizing trusts strategically to reduce potential tax liability. Trusts are currently incredibly under-utilized in estate planning. According to the U.S. Wealth and Worth Report, 48% of those surveyed do not have a revocable trust, 72% do not have an irrevocable trust, and 88% do not have a charitable trust. This makes advising on trusts a large area of opportunity for financial advisors to benefit their client’s estate planning.
Thanks to Vanilla, you can help your clients prepare for major changes in law, including the proposed capital gains tax rule. To see more examples of potential opportunities you can take action on directly through Vanilla, download a sample estate report below.
Thorough estate planning will make navigating this change easier for heirs
Estate planning on your client’s part now will help their heirs to navigate the new tax by helping establish the decedent’s basis more easily. As explained earlier, the estate tax levied would be based on the difference between the value at the time of purchase and the value at the time of death. Especially for ultra-wealthy clients with a large number of assets, this could mean tracking down decades worth of documents for every asset.
It is already advisable for you, as a financial advisor, to keep an organized file of your client’s estate planning documents. Companies like Vanilla can make this even easier to do by saving these documents in an easily accessible digital format. The best thing you can do to prepare your clients for these possible changes is to set up a meticulous digital record of these assets that live alongside the will and other estate planning documents.
This record will help your client’s heirs avoid estate planning nightmares like missing documents or an expensive, drawn-out estate transfer at the end of your client’s life. As the financial advisor overseeing the long-term health of your client’s fortune, this is an important way you can serve their estate and reduce the burden of that process on their heirs.
If you want to learn more about how you can keep your clients’ estate documents up-to-date with Vanilla, get in touch.
Help all of your clients prepare for possible changes in law
This article is for educational purposes only and should not be considered legal advice. If you feel that the information in this article is pertinent to your situation, you may wish to consult a qualified attorney for advice tailored to your circumstances.
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