Hank Adler, Under the Biden administration’s tax proposal, an appreciated real estate asset owned at death could result in income taxes due that exceed the net proceeds from sale of the asset after paying existing debt. Yes, having an asset where the fair market value of the asset is greater than the debt could result in taxes at death that exceed the net value of the real estate.
Currently, an individual must have net assets in excess of $11.7 million to be subject to zero estate taxes. The proposed Biden capital gains tax at death proposal would subject individuals with net assets not in the same zip code as $11.7 million of net worth to very significant new death taxes.
Biden makes two tax proposals that would create significant new taxes at death. Capital gains tax rates would be increased to 40.8 percent for total gains that exceed $500,000. Second, Biden proposes to tax capital gains at death excluding both the $250,000 gain on sale of a personal residence plus the first $1 million of capital gains.
A taxpayer who in 1997 purchased and has continued to own a rental property as his only asset could see his new death tax suddenly be a significant portion of his net worth and possibly exceed his net worth.
Let’s assume the taxpayer purchased the property for $3 million in 1997 and its fair market value in 2021 is now $12 million. Because of 25 years of depreciation, the asset has a tax basis of $500,000. Let’s also assume that the taxpayer borrowed $2.5 million when he purchased the property and has maintained that amount of debt for 25 years.
If this was his only asset, under current tax law, the beneficiaries of the taxpayer’s estate would have no federal taxes and would be able to sell the property and receive $9.5 million tax free after payment of the debt. Under the Biden plan, the estate of the taxpayer would need to pay a new death tax of roughly $4.2 million on the appreciation that occurred during his life. His beneficiaries would pay a 47% new death tax on the estate. With the stroke of a pen, a taxpayer not subject to any death tax under current law would lose almost 50% of his assets to taxes.
It gets worse. If our taxpayer had borrowed money on this asset to invest in ventures which did not become successful, to pay for college for his family, to gamble, or to make large charitable contributions, the new death tax could swallow the entire estate. If the taxpayer had a mortgage of $7.8 million upon death, there would literally be no money for the beneficiaries after the payoff of the mortgage; a 100% new death tax. If the taxes exceed the debt, it is unclear whether the government would get paid before the mortgage holder.
In what country on earth, could a net estate after taxes be reduced from $4.2 million to zero over night by passing a new law?
The entire idea of a capital gains tax at death is an ex post facto tax on appreciation earned before the law was enacted. It is not a change in tax rates; it is a tax on events prior to enactment.
The issue at play is the very nature of the government waking up one morning and changing rules tax laws that go back 100 years. Taxpayers have understood that if leveraged assets were sold, the income tax result would be significant. Taxpayers also understood that upon death, taxes were paid on the net estate, not an imagined sale of the assets.
Taxpayers planned their estates to provide for their children. Biden’s proposals will in many cases destroy such planning. And for taxpayers caught in this vice who would still have some assets in their net estates, their first step would likely be to eliminate or reduce previously planned charitable contributions to allow some distributions to their families.
Finally, there is the look forward impact of a doubling of capital gains rates and initiating taxes on death. Investors will look elsewhere than real estate. Housing stocks will not increase and rents will increase. It is axiomatic.