On March 25, 2021, Senator Sanders re-introduced the “For the 99.5 Percent Act.” And now, more than ever, property owners need to worry that it will pass this year and devastate the inheritance you can leave for your heirs. Any hope that the Republicans can hold this off in the Senate pretty much disappeared a day earlier (coincidence?) when Senator Manchin, the lead advocate for bipartisanship, said he wants an “ENORMOUS” infrastructure package, PAID FOR BY TAX INCREASES!
Since tax increases can pass the Senate with the votes of 50 Senators plus the Vice President, the chances that Estate and Gift Tax increases will not pass have become insignificant. Many of you acted in time after the November election to preserve Property Tax assessments for your children. But, sadly, many did not act in time to save their low Property Tax assessments. However, IF you anticipate your estate will grow to more than $3.5 million as a single person, or $7.0 million as a married couple, a delay in using your Estate and Gift Tax exclusions will likely cost your heirs millions.
As a result of the way the Sanders bill is structured, 2021 is probably the LAST CHANCE you will have to protect your heirs from many millions in death taxes. For a while, we have worried that the estate tax protections President Trump got us were of the “USE ‘EM OR LOSE ‘EM” variety. It is now pretty clear that they, and the best strategies for using even reduced exclusions, will die by 12-31-2021, and some are likely to die even sooner. [It is also likely that there will be numerous income tax changes made by the current Congress. I will only discuss a few which are represent key planning opportunities for income property owners.]
Do You Have Enough to Worry about Estate and Gift Taxes?
That depends on what you are worth today, and how many years it has to appreciate. For example, many 70- year-olds will live another 20+ years. If their net worth grows by only 4% per year, that means $1.00 of net worth would grow to about $2.20. So, a $5 million net worth would grow to about $11 million.
IF (and we cannot be certain) the Sanders estate tax exclusion grows at 1.5% per year), that would produce an estate tax of about $700,000 for a couple dying in 2042, and about $2.8 MILLION in estate taxes for an unmarried person.
If we do the same calculation for an estate starting at $10 million, the death tax would be nearly $6 MILLION for a married couple’s heirs, and nearly $8 MILLION for an unmarried person’s heirs.
IF you live longer (and many of you will), or do better with your investing, or start at a higher net worth, estate taxes will hit even harder.
And, if you leave property to grandchildren, the effective tax rate will be even higher due to the impact of Generation Skipping Taxes, which can increase the marginal death tax rate to 75% or near 80%, depending on the amount transferred! For our clients, we can generate a spreadsheet that takes into account your particular situation and assumptions, and model the impact of changes in life expectancy or growth rates.
Estate and Gift Tax Exclusion Rollback
The exclusion has grown from just $600,000 in 1997 to $11.7 MILLION per taxpayer this year. That means a couple can transfer $23.4 million with estate or gift taxes THIS YEAR, but the Sanders bill would reduce that amount to $3.5 million per taxpayer ($7 million per couple), effective January 1, 2022.
Increased Estate and Gift Tax Rates
The Estate and Gift Tax rate would go from 40%, to 45% (50% for transfers over $10 million, and 55% for transfers over $50 million). For a married couple, each transferring his/her share of $23.7 million, the combined reduction in the exclusion, and increase in rates, could COST THEIR HEIRS $7.5 MILLION (and more if their estate continues to grow)!
Elimination of Strategies to Leverage Exclusions
For decades, those of us who do advanced planning have used discounts and other strategies to enable clients to “leverage” their exclusions and pass multiples of the stated exclusion to heirs free of estate taxes. The Sanders bill eliminates some of the best strategies. But, if you act soon, you can still use them.
Repeal of 1031 Deferral for Like-Kind Exchanges
For decades, real estate investors have been able to defer capital gains by doing like-kind exchanges. In many cases, the deferral becomes permanent if you die holding the “up-leg” property and a common strategy was to “swap ‘til you drop”.
Although not included in the Sanders bill, President Biden proposes repealing exchanges for taxpayers with incomes above a limit (maybe $400,000, maybe $1 million). So, if you have substantial income, or would without the benefit of the ‘ 1031 deferral, and want to diversify, you may want to complete the exchange before the effective date of any Biden change to the 1031.
Repeal Step-Up in Basis at Death
Biden has also proposed repealing the Step-Up in Basis at death. The Step-Up adjusts the income tax basis at death on property in your estate (and in certain trusts) to the fair market value at your death. So, if you bought a property for $1 million years ago, have depreciated it down to $500,000, and you die with it in your estate when it is worth $2 million, Step-Up gives your heirs an income tax basis of $2 million, and permanently avoids taxation on $1.5 million of capital gains. [California also recognizes the Step-Up].
But, if the Step-Up is repealed, between Federal and State taxes on capital gains, at rates proposed for 2022 (maybe for part of 2021), that may mean $750,000 of tax if your heirs sell at date of death value. Furthermore, if your heirs continue to hold income property, the Step-Up can permit increased deductions for depreciation (as though they bought the property for the FMV at death). Such deductions can shelter all or most of the income from rental property from Federal and California income taxes. The loss of the step-Up reduces the “incentive” to hold property until you die.
Tax Capital Gains at the Same Rates as Ordinary Income
President Biden has also proposed. to tax capital gains at ordinary income rates, at least for taxpayers with more than $1 million of income (a threshold difficult to avoid in a sale of income real property in California).
Combined with the increase in top rates and the repeal of ‘ 1031 exchanges, this could be a massive increase in taxes for apartment owners who sell property after the effective date of Biden changes. The rate could go from nothing currently on many exchanges, to 39.6%.
And, if you had deferred income through exchanges or a Charitable Remainder Trust (“CRT”), you could see the deferred income taxed at higher rates than were in effect when you did the exchange or gift to a CRT.
This means you need to carefully consider whether deferral will save or increase taxes.
Will Tax Changes Depress the Value of Income Property?
The combination of low capital gains taxes, the ability to do exchanges, and the Step-Up in basis have been the cornerstone of the tax advantage of investment in income producing real estate.
Sadly, this advantage may disappear this year, as other proposals seek to tax capital gains as ordinary income, and the Step-UP in basis ceases to be a factor.
We worry that, absent this tax advantage, the value of income producing real property may also decline, particularly in a high-tax state such as California. The decline may, or course, be accelerated by tougher rent control and/or reduced ability to prevent reassessment for Property Taxes.
If, as we suspect, capital gains rates may be nearly 20 percentage points lower in 2021 than later years, it may make sense to consider a sale in 2021.
Can You “Beat the Clock?” — A Warning on Effective Dates
Usually, the date changes in law become effective are among the last things anyone worries about. But, in this era, with Congress more aware than ever of planning for “tax avoidance,” we worry a lot about effective dates.
New laws can be adopted to retroactively tax transactions occurring before the date of enactment.
Fortunately, the Sanders’ bill effective dates are mostly for next year, though some of the provisions that limit strategies are effective as soon as the bill is signed into law.
So, for major planning changes or transactions you want taxed under old law, to “beat the clock” we recommend, where possible, that they be implemented as early as possible in 2021.
However, if you wait until 2022, you will likely be “caught with your estate planning pants down!”
The Time for Planning is Now
My estate planning motto has never been truer. Now more than ever: If you fail to plan WELL NOW, plan to FAIL.” I cannot tell you that I KNOW what the law will be like in the future; but I am convinced that, with the bulging deficit and Democrats in control, that the tax environment is about to become a whole lot more adverse for apartment owners, particularly for those who want to leave value for their heirs. Some of the changes may be ones about which you can do nothing.
However, if you plan in time, you can protect your wealth from Estate and Gift Taxes by using your existing exclusions. Fortunately, modern estate planning can help you get property out of your estate and STILL retain access to it in case you need it to maintain your lifestyle.
The bottom line: If you think your net worth could grow before you pass much above $3.5 million as an individual, or $7 million as a couple, PLEASE, PLEASE spend some time with an experienced estate planner as soon as possible to evaluate what you can do to protect your wealth from substantial death tax exposure.
And, please do not wait until new laws have been adopted. It takes time to evaluate these strategies well in the context of your family situation. It takes even more time to implement them in the best way. You should not expect planning done under the pressure of a pending effective date to work as well for your family as planning that starts sooner.
I know from years of experience planning for income property owners that they care about planning for the future. Most of you have sacrificed for decades to build wealth not for you to spend, but to benefit your heirs. You probably did not build this wealth expecting to see much of it taken in unnecessary taxes when you die.
Don’t let the coming changes in tax law blind-side your family and steal years of hard work and sacrifice.
If you want to consult with me and my wife Hinda, we would love to conference with you by video or phone (until the COVID risk of in person meetings has faded). Such a conference can help you evaluate your risks and planning alternatives. But, if you do not do a conference with us, please find an estate planner familiar with a range of advanced strategies who is also well-versed in issues relevant to the owners of income properties.
Kenneth Ziskin, an estate planning attorney, focuses on integrated estate planning for apartment owners to save income, property, gift and estate taxes. He also provides trust and probate administration assistance after the death of a loved one. He holds the coveted AV Preeminent peer reviewed rating for Ethical Standards and Legal Ability from Martindale-Hubbell, a perfect 10 out of 10 rating from legal website AVVO.Com, and is a multiple winner of AVVO’s Client Choice Award. See Ken’s website at www.ZiskinLaw.com.
Ken also offers CONSULTATIONS FOR AOA MEMBERS in appropriate cases. Call him at (818) 988-0949. This article is general in nature and not intended as advice for clients. This article may be considered attorney advertising. Please get advice from counsel you retain for your own planning. (Drafted in late March, 2021.)