The government is a big fan of transactions. Anywhere money is moving, there’s a federal or state hand being held out eager to gather their share of the exchange. This is understandably controversial, and a perpetual point of debate on both sides of the aisle as we forever try to find the right balance between too much and too little when it comes to taxes.
Over the last couple of decades though, the government has been distancing itself from one type of transaction in particular, the passing down of inheritances and estates.
Fundamentals to know
- An estate is basically all the money and property a person owns when they pass away. As silly as it sounds, it acts as its own unique entity that can be taxed.
- An inheritance is just as you probably guessed it—money, property and other assets that are passed to beneficiaries whether or not the original owner has died.
- An estate tax is not an inheritance tax, and vice versa. An estate tax is assessed on the estate after the owner's death, before its assets are distributed; while an inheritance tax is imposed on a beneficiary when they receive assets.
- Most people don’t have to pay an estate tax because the federal estate tax kicks in only once your estate is valued above $11.7 million in 2021. And the portion of the estate that surpasses $11.7 million is taxed at 40% in 2021 (simply put). Considering this high level, the vast majority of estates get passed to beneficiaries without tax implications.
- And there is no federal inhertance tax.
- The caveat:10 states also impose their own estate tax, while 5 impose inheritance taxes, and Maryland does both. And inheritance taxes can get extremely convoluted on the state level.
History lesson: literally death and taxes
In 1976, the federal estate tax exemption was just $60,000, which equates to about $415,000 today when we consider inflation. For the next 30 years it steadily increased to $600,000, then jumped to $1 million in 2002.
Then came the Tax Relief, Unemployment Insurance Reauthorization and Job Creation Act under Obama in late 2010, pushing the exemption further north. This was meant to expire and eventually regress after dealing with the 2008 financial crisis, but along came the American Taxpayer Relief Act in 2013 to keep exemption levels up.
It hit a plateau of $5.5 million until 2017 when Trump doubled it to $11.1 million, which is about where it sits presently ($11.7 million).
Where we are now
Yeah, we get that it's not the easiest thing to understand given all the jargon and history. But the larger point here is that we’ve been drifting further and further from shore when it comes to the taxation of estates, and discussions are being had about reigning that back in.
This comes partly by way of Biden’s proposed changes to the capital gains tax rate, as well as exponentially seeking to eliminate what’s known as the stepped-up basis.
The means to the end
Joe Biden wants to raise the long-term capital gains tax on Americans making over $1 million dollars per year from 20% to 39.6%, pointing out that wealthy investors are paying less on capital income than working income, and suggesting it would impact “only about 1% of Americans.”
There’s also a circulating proposal to get rid of the stepped-up basis. The stepped-up basis allows beneficiaries to claim their inheritance at its present fair market value, eliminating any tax on gains made based on the original owner's investment amount.
For example, you inherit a business from your family that started for $100,000 and it’s now worth $20 million. With no step-up cost basis, you’d be liable for a capital gains tax on the value of the business that remains above the $11.7 million dollar exemption line. The step-up rule eliminates this by stepping up the cost basis of your inherited asset from $100,000 to its current fair market value of $20 million, effectively resulting in a $0 tax bill on the gain.
These potential changes would combine to create a much higher effective tax rate on those estates that did reach beyond that lofty $11.7 million dollar threshold.
So, will there be a comeback?
At the moment, it seems doubtful that this would all pass. Some of it may get through, some may not. It could be modified, or it could flop entirely. If it were to pass in some similar manner, it’s possible we see the estate tax done away with entirely at some point if Congress feels it’s too extreme.
Regardless, it’s a topic that will likely live on the debate floor of Washington for several months, years, decades to come.