Are We in Danger of Losing the Step Up in Basis (Part 2)

     Last week we were discussing potential changes to the tax laws proposed by President Obama that would eliminate the step up in basis.  Obama claims the target is wealthy Americans but the change could have a much bigger impact on average middle class citizens.

     That’s because with the federal estate tax exemption currently at $5.43 million, only estates larger than that number must pay federal estate tax.  While New Jersey estate taxes kick in on estates greater than $675,000, removing the step up in basis still means that many heirs would have to pay an additional tax on assets they inherit.

     Let me give you a very common scenario we see.   Mom passes away and leaves her assets to her children.  Those assets include Exxon stock she and Dad bought many years ago.  The stock is now worth $500,000.  The total estate is worth $1,000,000, including her home which Mom and Dad purchased for $20,000, which is now worth $400,000.

     Under current tax laws the children get a step up in basis on both the stock and the home.  Presuming they sell the home immediately after Mom’s passing, there would be no capital gains tax owed on the home.  The new basis would be the sale price.  The stock would also get a step up in basis.  The estate would owe approximately $25,000 in New Jersey estate tax and no federal estate tax.

     If the step up is eliminated, the estate would still owe the same New Jersey estate tax but now there would be an additional capital gains tax.  Obama’s proposal does suggest that some amount of capital gain be excluded from tax but let’s assume in my example there is no exemption.  Let’s also assume that the capital gains tax rate is 25%.  In that case, the tax on the home gain would be $95,000.

     The tax on the stock would be more complicated to calculate.  We would need to go back and determine the original basis, what Mom and Dad bought the stock for with some adjustments for stock splits.  Those records may not be easy for the children to get, since they didn’t buy the stock themselves and their parents may not have kept records.  If the stock was bought at different times or there were stock splits that can be a nightmare.

     In any case, if the stock was held for many years then it’s safe to assume there would be substantial capital gains and the tax could easily exceed $100,000.  Add that to the tax on the sale of the home and you can see that a small estate of $1,000,000 could have additional tax of $200,000 or more, on top of the estate tax.

     Sure, the wealthy would be subject to this additional tax as well but Obama clearly misses the mark and he misleads us in doing so.  He claims that he wants “wealthy Americans to pay their fair share”, but he doesn’t tell us that in the process everyone else will be paying more in taxes.