United States President Joe Biden speaks about the economy during a visit to Cuyahoga Community College in Cleveland, Ohio on May 27, 2021.
Evelyn Hockstein | Reuters
The rich may have another reason to fear President Joe Biden’s proposal to revise inheritance taxes: they may have to sift through decades of documents to find out what they owe Uncle Sam.
To fund his American family plan, Biden proposes higher taxes on capital gains and income for the wealthiest families.
He also calls for the elimination of a decade-old loophole that allows individuals to inherit valued assets at market value without taxes on unrealized gains. This tactic is known as “topping up the base at death”.
Biden proposes ending this “top-up” on profits greater than $ 1 million for individual taxpayers – $ 2.5 million for couples – and ensuring that profits are taxed when property is not for charitable Purposes is donated.
Coupled with attempting to increase long-term capital gains rates from 20% for households with sales above $ 1 million to 39.6%, wealthy heirs could receive a pile of taxes.
However, for certain assets, it might be difficult to determine Uncle Sam’s cut. This is because the base – or the owner’s original investment in the asset – can be difficult to trace.
“How do you rate the base, especially if the person who had the best chance of responding has passed away?” asked Ed Zollars, CPA and Partner at Thomas, Zollars & Lynch in Phoenix.
Basis at death
The basis is important because the amount you pay in taxes when selling an asset is based on the difference between the purchase price and the market value.
Without the “increase in base at death”, the heirs would receive the asset on the basis of the deceased. It also means that the heir could face a heavy tax burden on profits that have accumulated over decades.
This can be a mystery to complex assets, including real estate and small businesses, which rely on years of documents to determine the foundation.
Owners of flow-through companies – such as limited liability companies – are subject to a decline in base when they make distributions out of their business. Meanwhile, the capital invested in the business increases the base.
“For a flow-through company that has been around for 45 years, I would theoretically have to file tax returns for 45 years,” said Brad Sprong, national tax officer for KPMG Private Enterprise. “Often times, records are not readily available, and transcripts are difficult to obtain from the IRS.”
Real estate is another complication. Owners can defer capital gains from real estate by exchanging one investment property for another on what is known as a 1031 exchange.
Investors who conduct these exchanges for many years and fail to keep proper records risk losing track of their base over time. This can add complexity as they sell the property and try to figure out the tax burden on capital gains.
Zollars once had a client selling properties that were bought in the 1970s and had gone through 1031 multiple stock exchanges. “They didn’t keep any real records,” he said. “This is the manual research where you go to the county assessor’s office to find records of sales and purchases that are indirect at best.”
Even the tracking base for long-held publicly traded assets can get complicated.
It wasn’t until 2011 that custodians, mutual funds, and brokerage firms were required to comply with federal tracking rules. Investors with holdings prior to this time period may have base tracking issues if they have switched brokerage firms or have been on dividend reinvestment plans.
“It gets complicated when you keep reinvesting,” said Tim Steffen, senior consultant at Pimco Advisor Education. “Sometimes people forget they are doing this. They forget they are getting all of those extra basics and finding the records to report it can be a challenge.”
Zero base vs. estimated base
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If you cannot determine the base – and therefore the amount of tax owed – it will be considered zero.
According to Biden’s proposal, this would mean that an inheritance would be taxable on the entire appreciation of the asset, minus the exclusion of $ 1 million for individual taxpayers ($ 2.5 million for couples).
If, in the event of a sale, investors are tracking down the long held base and documents are running short, they may be attempting a good faith estimate to determine the tax hit. Be warned: the IRS can challenge your estimates and practices.
Here are three steps to staying one step ahead of a battle with the tax officer:
Find your base now and collect all supporting documents. When it comes to real estate and small businesses, appraisal papers and records showing property reinvestment and improvements can also help you triangulate your base.
Maintain pristine records, including statements that show when you sold your inventory or when you received distributions from your partnerships.
Make the base discussion a part of your estate plan. Just as your heirs should know where your will is, they should also have an idea of your base in your wealth. Share these documents with them ahead of time and save yourself the extra work of figuring out what you originally paid for an asset.
Still can’t justify the base? Consider giving to charity. If lawmakers put an end to increasing deaths, assets with a hard-to-determine basis could be good candidates for donation, Steffen said.
You can get a tax deduction based on the market value of the asset when you donate it to a qualified charity. Think about it, but don’t act yet.
“Wait for the details,” said Zollars. “Any proposed bill is just a proposed bill, but getting your base together isn’t bad.”