United States President Joe Biden delivers economic remarks 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 dig through decades of documents to find out what they owe Uncle Sam.
To help fund his American Families Plan, Biden is proposing higher taxes on capital gains and income for the wealthiest families.
He also calls for the removal of a decade-long loophole that allows individuals to inherit valued assets at market value without taxing the unrealized gain. This tactic is known as “raising the base on death”.
Biden proposes ending this “base increase” on profits greater than $ 1 million for single taxpayers – $ 2.5 million for couples – and ensuring that profits are taxed when property is not donated to charity becomes.
Coupled with an offer to increase long-term capital gains from 20% for households above 1 million to 39.6%, wealthy heirs could expect a pile of taxes.
But for certain assets it might be difficult to pinpoint Uncle Sam’s cut. This is because the foundation – or the owner’s original investment in the asset – could be difficult to track.
“How do you rate the foundation, especially if the person who had the best answers to it 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 of tax you pay in selling an asset is based on the difference between the purchase price and the market value.
Without the “death increase”, the heirs would receive the assets with the inheritance basis. This also means that the heir could incur a high tax burden on the profits accumulated over decades.
This can pose a puzzle for complex assets, including real estate and small businesses, that rely on years of documentation to determine the foundation.
Flow-through company owners – for example, limited liability companies – are subject to a base cut if they take 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 go through 45 years of tax returns,” said Brad Sprong, national tax chief for KPMG Private Enterprise. “Often times, records are not readily available, and it is also difficult to get transcripts from the IRS.”
Real estate is another complication. Owners can defer capital gains from real estate by swapping one investment property for another in what is known as a 1031 exchange.
Investors who have been doing these exchanges for many years and failing to keep proper records risk losing track of their base over time, which can add complexity when selling the property and trying to figure out the capital gains tax bill.
Zollars once had a client selling properties that were bought in the 1970s and had gone through 1031 multiple IPOs. “They didn’t keep any real records,” he said. “This is the manual research that involves going to the district court office to find some records of sales and purchases that would be indirect at best.”
Even the tracking base for long-held publicly traded assets can get complicated.
Custodians, mutual funds, and brokerage firms did not have to comply with federal tracking rules until 2011. Investors with holdings prior to this period may have trouble finding the base if they switched brokerage firms or had dividend reinvestment plans.
“It gets complicated when you keep reinvesting,” says Tim Steffen, Senior Consultant Education at Pimco. “Sometimes people forget that they are doing this. They forget that they are getting all of this extra foundation and finding the records to report this can be a challenge.”
Zero base vs. estimated base
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If you cannot determine the assessment base – and thus the amount of tax owed – it is considered zero.
According to Biden’s proposal, this would mean that an heir would have to tax the entire appreciation of the asset, minus the exclusion of $ 1 million for single taxpayers ($ 2.5 million for couples).
Right now, when investors find the basis for long-term investments in the event of a sale and lack the documentation, they can attempt a good faith estimate to determine the tax losses. Be warned: the IRS can challenge your estimates and methodology.
Here are three steps to staying one step ahead of a battle with the tax officer:
Find your base now and collect all the evidence. When it comes to real estate and small businesses, valuation papers and papers demonstrating property reinvestment and improvements can also help you triangulate your base.
Maintain impeccable records, including statements showing when you sold your inventory or withdrawn distributions from your partnerships.
Make the base discussion a part of your estate plan. Just as your heirs should know where to find your will, so should they know your assets. Share these documents with them in advance and save them the extra hassle of figuring out what you originally paid for an investment.
Still can’t prove the foundation? Consider charitable giving. If lawmakers abolish the top-up on death, 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 an appropriate charity. Think about it, but don’t act yet.
“Wait for the details,” Zollars said. “Every bill is just a bill, but it’s not bad to put your foundation together.”