Implications of Eliminating the Step-up Rule


By Tidemark Team

In our first two editions of Tidemark Talks, we discussed the potential impact of taxing capital gains as ordinary income and limiting 1031 exchanges to the first $500,000 in gain, both of which are key components to the President’s American Families Plan currently being debated in Congress. In this post we take on a third component of the plan, taxing capital gains at death, which would effectively eliminate the step-up rule, a 100-year-old estate planning strategy employed by millions of investors large and small across the country.

In simplest terms, the step-up rule allows an asset to be passed on from one generation to the next at a basis equal to the market value of the asset at the time the descendent dies. This allows those who inherit the asset to immediately sell at the ‘stepped-up’ value without incurring tax liability. The step-up rule was created back in 1921 to protect families from having to liquidate assets like family farms and manufacturing operations that lacked the liquidity to pay hefty taxes and continue operations.

In 2021, the estate tax threshold for individual estates is $11,700,000. So, for estates valued at less than that, no estate tax is due at death, but the step-up rule remains in play. That means heirs to an estate worth less than the threshold would receive all the assets, sell them and pocket the entire value of the estate tax-free. This is also why so many investors hold onto their assets rather than sell them or pass them along to their heirs while alive, which would precipitate significant tax events. This is especially true of the baby boomer generation (those born from 1946-1964) who are sitting on tens of trillions of dollars in assets they intend to pass along to their heirs at death a step-up in basis.

President Biden’s American Families Plan calls for the assets of an estate to be taxed as capital gains at death based on their current fair market value, whether or not the assets are sold. So, the estate would pay the capital gains taxes, along with estate taxes on the estate’s value above the current year’s estate tax threshold. The heirs would then get a new basis at fair market value for assets they retain.

We won’t even break out the calculator to make our point on this one. The tax implications to this proposal are massive, and the impact will force a complete restructuring of the estate planning strategy for millions of investors. For those completely liquid and debt free, the consequences will be profound, but at least there is liquidity to pay the new taxes. But, what about investors who carry a lot of debt or those whose asset value is in equipment or other operating assets that would be difficult to sell? It could be devastating and we can envision businesses being dismantled and sold off just to meet a tax obligation that occurs after the death of the business owner.

The President’s plan does offer some protections for smaller estates. As proposed, the first $1 million in estate value would be exempt, and family businesses that continue to be operated by family heirs would be protected.  Other exemptions may surface as the bill moves through the Congress, but it is too early to say just how things will all work out. To pass, the legislation will have to be pushed through using a process called ‘budget reconciliation’, which would allow the legislation to pass with just 50 votes in the Senate, plus the vote of the Vice President (technically the President of the Senate) who votes only to break ties. So, the American Families Plan, as controversial as it is, has a path to passage, but it requires a vote in the House and Senate almost entirely along party lines. The current timeline calls for the legislation to come to a vote in the House and Senate by the end of September. The new step-up rule as we now know it would disappear after January 1, 2022, just five months from now.

We highly recommend that you consult with your trusted advisors to get a good understanding how this and other changes to the tax code could impact you based on your unique circumstances. In further posts, we will share our thoughts on the impact to property values and market conditions the American Families Plan may bring. Stay tuned.