By: Doug Dean, CPA | ddean@deandorton.com
Tax proposals are flowing out of Washington, D.C. almost weekly. The most recent proposals (at the time of drafting this article) were those included in a Department of the Treasury May 2021 document titled “General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals.” Unofficially, the document is called the “Treasury Greenbook,” and in this article I’ll refer to it as the Greenbook. This article will focus on only three of almost 50 topics the Greenbook covers in its over 100 pages. Two of the topics to be discussed concern individual income taxes and the third concerns real estate investors and operators.
Before discussing these topics, please note that these are only proposals, and they may never become law. But, if they are enacted, they will change the federal income tax landscape in significant ways.
Increase in Marginal Tax Rates for High Earners
Under current law, the top tax rate on ordinary income has been 37% since 2018 and is scheduled to remain there through 2025, after which it is scheduled to revert to 39.6%. For 2021, this top rate applies when taxable ordinary income exceeds $628,300 on a married couple’s joint tax return and $523,600 on a single individual’s return.
The proposed change would raise the top rate to 39.6% and would apply this rate to taxable ordinary income exceeding $509,300 and $452,700 for 2022 joint and individual filers, respectively. The change is not proposed to take effect until 2022.
The rate change is much talked about in the general press, but not the part of the proposal which would apply the top rate to a lower level of income.
Taxation of Capital Gains and Most Dividends
The proposals regarding this topic are comprised of major changes in longstanding tax policy. The first such change would tax long-term capital gains and qualified dividends (together called in this article “capital gains” and now taxed at a top rate of 20%) at ordinary income rates for those with adjusted gross income (“AGI”) exceeding $1,000,000. An example in the Greenbook demonstrates how this would work in a situation that otherwise may not be clear: A taxpayer has $900,000 of ordinary income and $200,000 of capital gains making up $1,100,000 of AGI. Because AGI exceeds $1,000,000 by only $100,000, only $100,000 of the $200,000 capital gains would be taxed at the top ordinary income rate (now 37%, but proposed to be 39.6%, as discussed above). The Greenbook does not describe whether a trust would have the same $1,000,000 threshold.
This change is proposed to be effective retroactive to the date it was announced, apparently April 28 of this year.
Another significant part of the proposals would treat transfers of appreciated property by gift or at death as if the property had been sold. In other words, gift transfers and death would be realization events, triggering taxable gains. In the case of death, the property’s basis would be the decedent’s basis. To alleviate some of the impact of dual tax (income and estate) on the same measure of wealth, the income tax on the gain would be deductible on the decedent’s estate tax return. Assuming the proposals already discussed are in place and are fully applicable in a situation, let’s consider what the federal-only tax impact would be on an asset with a cost basis of $1,000,000 and a date of death value of $2,500,000. The $1,500,000 of gain would be subject to a 39.6% income tax, or $594,000, and the 3.8% net investment income tax, another $57,000. The $2,500,000, net of the $594,000 income tax on the gain, would be subject to a 40% estate tax (at today’s rate, but other outstanding proposals may increase the rate); that’s another $762,400. That’s total federal tax of $1,413,400 on the asset with a $2,500,000 value, 56.5% of the asset’s value. The higher the ratio of the asset’s gain to its value at death, the higher the potential tax rate on the asset’s value.
A related provision would tax unrealized gain on property owned by a trust or other non-corporate entity if the property has not been the subject of a recognition event within the prior 90 years (!). The testing period would begin January 1, 1940, so the first possible recognition event would be December 31, 2030. Further, transfers of appreciated property into, and distributions of such property from, a trust or other non-corporate entity would be recognition events.
The recognition of gains in the various instances described in the previous two paragraphs would require, if enacted, determining the fair market value of property (since no arms-length sale has determined the property’s value). This would create a huge demand for appraisal services, and it would invite a multitude of disputes, which often tend to have lengthy dispute resolution time periods and considerable expense. And, many common non-tax motivated transactions would be stifled due to the tax cost.
The Greenbook goes on to say that transfers of appreciated property by a decedent to a U.S spouse or to a charity would not be subject to gain recognition, but it does not address such transfers made during the transferor’s life.
The proposal provides some exclusions in the case of appreciated assets transferred by gift or inheritance. Each person would be granted $1,000,000 of exclusion of appreciation from recognition, so a married couple would have a gain exclusion of $2,000,000. Much like the unified system of gift and estate taxation, the gain exclusion would apply to gifts made during the transferor’s lifetime (until the limit is reached), then would apply to appreciated assets at death.
Also, the payment of tax on certain (not described) family-owned and operated businesses would be deferred until the interest in the business is sold or ceases to be family-owned and operated. For other illiquid assets, an election would be available to amortize the tax liability on appreciation at a fixed rate over 15 years, but this financing would not be available for appreciated marketable securities.
The proposal to tax gains on property transferred by gift or at death would become effective in 2022.
Considering the radical nature of the various changes proposed in the taxation (amount and timing) of gains, we have to wonder about the likelihood of enactment. My best guess – and it is only a guess – is that not all the proposals will be enacted, but some will be, at least in part, and I’d be surprised (but not shocked) if any of these changes become effective retroactively.
More Limitations on the Use of Like-Kind (1031) Exchanges
The ability of owners to use 1031 exchanges to defer taxes on gains has been whittled-down over time. Currently, such exchanges are available only for real-estate held for business use or as an investment. A proposal described in the Greenbook would further limit the use of 1031 exchanges. Under the proposal, a taxpayer would be able to defer gain recognition on only up to $500,000 of gain ($1,000,000 on a joint return) per year.
This change is proposed to be effective for exchanges completed in tax years beginning after 2021.
Notable Omissions from the Greenbook
Several changes that have been proposed by politicians and talked about extensively did not make into the Greenbook. Some of the more notable of these are:
- Elimination of the 20% pass-through deduction on qualified business income,
- Revising estate and gift tax rates and exemptions,
- Repealing or raising the $10,000 cap on state and local tax deductions,
- Imposing Social Security tax on subject income exceeding $400,000, and
- Imposing a 28% cap on the tax benefit of itemized deductions.
Does this mean these proposals are “off-the table?” No, I don’t believe we can draw that conclusion. We should not be surprised to see any of these continue to be promoted by their backers.
A Final Word
The tax system is used more all the time as a tool to advance social agendas, and the number, frequency, and impact of changes has made the tax system an ever-growing challenge to learn, apply, and administer. Intelligently planning one’s financial affairs is extraordinarily difficult in the absence of any ability to feel confident of what the future rules will be. We can plan based only on our best guesses, and when the rules change in ways that are contrary to our best guesses, we can only hope we have time to adjust or that we won’t suffer greatly because our crystal balls weren’t working very well.
This article was originally published in News & Views (Dean Dorton’s quarterly newsletter).