The Hidden Probate Real Estate Tax Bomb In Biden's Economic Plan
The proposed change would end the process of real estate heirs taking probated property on a stepped-up basis and instead require them to pay capital gains taxes on all appreciation that accrued on the property before their inheritance, according to Erica York, an economist with the Center for Federal Tax Policy at Tax Foundation.
Biden's plan also would increase the capital gains tax rate for some people, requiring them to pay up to a 43.4% tax rate, she said. The current upper limit is 23.8%.
"Currently, when a person dies and leaves property to an heir, the basis of that property is increased to its fair market value," York said, describing the "step-up in basis" process that now governs how capital gains are taxed on inherited real estate.
York offered an example. Under existing law, if someone purchased a property when it was valued at $1M and died when it had reached a fair market value of $5M, the owner's heirs would inherit the property at a stepped-up basis of $5M. As a result, heirs under current law do not have to pay capital gains on the $4M in appreciation that accrued before the original owner's death, and if they were to sell the property down the road, they would only pay capital gains taxes on any value above $5M.
Biden's proposed tax plan goes in the opposite direction and would put those heirs on the hook for paying capital gains taxes on the original $4M in appreciation, plus any other profits earned above the current market value once the heir sells the asset. The hit to their profits has the potential to be massive.
Tony Trahan with tax advisory firm KE Andrews out of Dallas-Fort Worth said clients with family trusts, ranches and large swaths of land are starting to get nervous about this plan, particularly if they are older and expect to leave assets to their heirs.
"I think a lot of them are starting to accelerate some of the planning that they may not have done previously, or they may have thought it could wait a couple of years," Trahan said.
Biden's plan also would increase the tax rate for some people. Under current law, the top tax rate for capital gains is 20% plus an additional 3.8% net investment income tax for investors above a certain income threshold, York said. That could significantly increase, as Biden proposes taxing gains at ordinary income tax rates for taxpayers with more than $1M in income.
"This would essentially add a fourth tax bracket to the capital gains schedule of 39.6% on income above $1M, meaning the top rate could reach 43.4% when we include the 3.8% net investment income tax," York said.
There is some misinformation being spread about Biden's tax plan that is alarming CRE professionals. For example, Eric Toder, co-director of the Urban-Brookings Tax Policy Center at the Urban Institute, has dispelled rumors that all real estate will be taxed at 40% under the Biden plan.
But Toder said there will be changes in how real estate is inherited, particularly when it comes to higher-priced assets and individuals with incomes above $400K.
Numerous exemptions would limit what assets get hit with more capital gains taxes under Biden's plan, including caveats in the law that protect principal residences and normally priced real estate assets. The first $200K of gains for married couples and $100K for singles would be exempt, Toder said.
It's unlikely people with middle-class incomes would see a huge change in how capital gains are assessed when inheriting property, he said.
"If your other income, including the capital gains, is less than $400K, then you are not affected by this proposal," he said.
And for the higher 39.6% proposed capital gains rate to kick in on inherited property, the heir would have to have a total income, including any capital gains, of more than $1M; otherwise, the lower 20% tax rate applies for those with incomes over $400K but under $1M, Toder noted.
Toder also said inheriting parties would get a standard break when offloading a principal residence.
"You have the exemption of current law of the first $250K for singles and $500K of gains for joint [filing couples] for your personal residence, and that exemption would remain in effect."
But for commercial real estate, where values appreciate rapidly and property values are high, a hefty tax bill is in the cards under the plan, analysts say. For example, a $1M property that appreciates to $5M in value during an owner's lifetime would end up with a seven-figure tax bill.
There are some unknowns in Biden's proposal, and how those are worked out could hit commercial real estate heirs even more. For one, it's unclear if death itself becomes a "taxable event" that forces heirs to pay capital gains taxes on all appreciated value at the time of their inheritance.
A second possibility is the Biden plan may allow heirs to inherit real estate on a carry-over basis, so they only have to pay for the years of appreciation when they sell the asset, not at the time of inheritance. Another option is that heirs could spread their taxes out over time, according to Toder.
"Assuming the former method [of the death itself becoming a taxable event], when the heir received the asset they would owe capital gains tax on the $4M gain at ordinary income tax rates," York explained. "At a 39.6% statutory rate plus the 3.8% net investment income tax, this would make for a $1.736M tax bill [upon inheritance]."
This is a dramatic difference considering current tax plans only require inheriting parties to pay for profits earned above the current fair market value recorded at the time the heir sells the asset on their own.
The potential impact of this proposed change on owners of commercial real estate is substantial, Trahan said.
"Think about somebody or a family that has held multifamily assets for years and years, and they have doubled or tripled their appreciation," Trahan said. "The heir that inherited it would have to figure out how to come up with that income tax on something that has tripled, so it's a difficult thing for sure."