The current annual US budget, as proposed by President Obama, includes some significant potential changes in tax law.
Among these are proposals that could result in higher capital gains taxes on inherited property, an end to most tax-deferred real property exchanges, and increased taxes on S corporation dividends.
In the estate planning category, the President would like to end the step-up in basis rule and replace it with a mandatory sale at death rule.
The step-up in basis rule allows property that has appreciated in value to be passed to an heir without either the estate or the heir having to pay capital gains tax. The heir's "basis" in the property (the amount, equivalent to a purchase price, deemed the heir's initial value for tax purposes) is what the property is worth upon the date of death. Only appreciation from the date of death will be subject to any capital gains tax. Under Obama’s proposal, the estate will have to pay tax on any capital gains as of the date of death. As I read the proposal, these taxes are in addition to any estate taxes.
For example, assume your mother purchased an acreage 20 years ago for $30,000. At the time of her recent death, the property was worth $500,000. Under the current law, you would receive the land with a new "stepped-up" basis of $500,000. Neither your mother’s estate nor you would pay any taxes on the $470,000 gain.
Under the president’s proposal, your mother’s estate would pay up to $88,060 in tax on the gift to you (the first $100,000 of gain would be excluded from taxation), leaving that much less to distribute to you and any other heirs. Even worse, suppose the acreage was the only property of significant value your mother had owned. It’s conceivable that the estate would have to sell the property to raise money to pay the tax, then distribute the remainder of the sale proceeds to you. In effect, the new tax law could eliminate your ability to inherit the land and reduce the value of what you receive by $88,060.
The next proposal in the budget is to cap any 1031 tax-deferred exchanges of investment property. This proposal would also completely end all like-for-like deferred tax exchanges for collectibles and art.
The 1031 is a popular real estate tax planning provision where an investor can exchange a property for another "like-kind" property and defer the capital gains tax until the property is eventually sold for cash.
The President wants to limit the deferred gain to $1,000,000 in any one year. Any gain above the limit would be taxable at up to 23.8%. Since there is inherently no money changing hands in an exchange, the investor would have to have sufficient additional funds available to write the US Treasury a check. This would effectively end the 1031 exchange as a tax planning tool for all but the smallest of investors.
Another disturbing proposal is to apply the 3.8% "Obamacare Tax," (a net investment tax for those with adjusted gross income over a certain threshold) to S Corporation dividends. Currently, shareholders don’t pay this tax on such dividends. The proposal would now tax all pass-through income as self-employment income, subjecting S Corporation dividends to the tax.
The chances for any of these proposals to become law in 2016 are remote, given that Congress is currently controlled by Republicans and we are in an election year. Yet the proposals may indicate some of the revenue possibilities lawmakers are looking at. It's a good idea to keep those possibilities in mind in considering your own estate and tax planning.