The Missing Piece in Estate Plans

  • Personal finance
  • 3/16/2021
Business woman in meeting with colleagues in cafe

Congressional proposals could bring changes to income, estate, and gift tax rules, and individuals planning to transfer wealth should consider these factors.

Key insights

  • Traditional estate planning strategies for transferring property during your lifetime might not be feasible if significant tax changes are enacted.
  • Congress is considering various proposals that could vastly change how investments are taxed and, therefore, the type of assets individuals may want to transfer during their lifetime.
  • To gain leverage as rules potentially change, financial planners will need to understand the nuances of how income tax consequences, estate taxes, and gift tax rules are increasingly interrelated.

How might congressional priorities affect your financial plan?

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Given the Democrats’ control over the U.S. House of Representatives, U.S. Senate, and administration, some individuals are making plans to transfer wealth — while also trying to protect their assets. Current Democratic proposals highlight the need to consider potential changes to income, estate, and gift tax rules — and how they are interrelated — now. However, prior to taking any steps, be careful not to overlook the importance of income tax, cash flow, and financial planning.

Traditional strategies for transfers during your lifetime

Many estate plans involve transfers during your lifetime. Depending on the estate planning technique, these transfers are typically made with assets expected to increase significantly in value (often shifting future appreciation to a younger generation). It is also highly preferable that the owner has a high basis (generally, cost) in the property, meaning there is no or minimal appreciation since the owner acquired it. That way, the transferee receives a carryover basis and “steps into the shoes” of the transferor income tax purposes. The built-in gain upon transfer is deferred until the sale of the property.

In comparison, low-basis assets are typically reserved for transfers at death to obtain a “step-up” in basis to fair market value — and completely avoid income taxes on the appreciation.

New cash flow and income tax issues

A proposal by Democratic leadership could significantly change how investments are taxed, and possibly flip which type of assets you might transfer during your lifetime.

Under Senate Finance Committee Chairman Ron Wyden’s proposal “Treat Wealth Like Wages,” dividends and capital gains would be taxed at ordinary income rates of up to 43.4% (as opposed to 23.8% under current rules). More significantly, the “mark-to-market taxation” rules in the proposal would tax unrealized appreciation in property each year, regardless of whether the asset was sold.  This acceleration in taxes could result in significant cash flow issues. (How do you pay for taxes when your cash is tied up in the investment?)

One of the most significant changes proposed is the treatment of highly appreciated assets. It is possible, and anticipated by Chairman Wyden, that built-in gains accrued prior to the enactment of the proposal would not escape taxation. Taxpayers that may be subject to mark-to-market taxation rules may want to consider transferring low basis property now to individuals who are not as susceptible to these changes. Otherwise, they risk paying up to 43.4% of federal income taxes on the gain, regardless of whether the asset is sold.

Fortunately, not all taxpayers would be subject to the mark-to-market rules. It appears that the proposed acceleration of income taxes would only affect taxpayers that exceed $1 million in income or $10 million in applicable assets, for three years in a row. These limitations – and income tax and financial planning opportunities – may motivate lifetime transfers in 2021 even more than anticipated changes to the estate tax rules.

However, another compelling factor is a potential change in the gift tax exemption, which is the amount an individual may transfer during lifetime without paying any gift tax. Democrats are interested in reducing the $11.7 million limit down to $1 million. The administration is also considering whether to treat lifetime gifts as “realization events,” which would trigger an income tax on any unrealized gains upon transfer.

Although there is no guarantee that transfers made prior to any legislative changes would be grandfathered, advisors believe the sooner you take steps in implementing, the more likely a comprehensive plan can help you achieve your goals.

Growing interrelatedness of taxes and financial planning

Qualified financial planners have integrated income tax consequences into their recommendations for years. However, understanding the nuances between taxes and financial planning would become even more important under both the mark-to-market rules and higher tax rates for investment income.

In addition to the income and asset thresholds, careful planning could help you make the most of potential exemptions and exceptions. This includes utilizing the benefits of tax-preferred savings accounts and identifying which types of assets help leverage your tax preference. You may also want to consider the viability of other tax-favorable investments (such as qualified opportunity zone funds) in evaluating your financial options.

Take a comprehensive approach

Given the potential for changes with new legislation, all aspects of a financial plan should be factored into your analysis and strategies before taking steps to implement.

Legislative proposals evolve. We’ll watch for changes in thresholds, how assets in trusts may be treated, whether debt could reduce the value of your applicable assets, how the lookback charge on real estate sales will operate, and transition rules.

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