What Bay Area Residents Should Know About the Joe Biden Tax Plan

This blog piece was co-authored by Adam Govani, CFP® and Emily Hazelroth, CFP®.

On April 28, 2021, President Biden announced the American Families Plan (AFP). As a follow-up to the recently released American Jobs Plan, the AFP proposes tax increases in order to fund spending primarily on childcare, education, and family support. While we would not opine on the efficacy of both the taxation and spending side of the equation, we believe it is essential that we provide perspective around how tax changes may influence the financial plans of Bay Area residents, such as our clients. Unfortunately, there is both exaggeration and omission in coverage of the AFP, primarily on the taxation side. Our goal is to provide a factual overview of the Biden tax plan with regards to:

• what has been proposed
• where we are in the process
• who it would affect
• when changes could take place
• what you should (and should not) do

What the Biden Tax Plan Proposes and Where It Stands

The AFP combines tax increases, primarily on high-income earners, to fund everything from increased IRS enforcement to an expanded free education system. It is important to note that the AFP is not yet proposed legislation; rather, it is the administration’s official view on public policy implementation. In much the same way the presidential budget proposal is largely ceremonial, it will be up to Congress to complete the legislative process before President Biden has a chance to sign any of the proposed changes into law. Furthermore, there is no guarantee that any drafted legislation would be passed by either (or both) chambers of Congress. Tax changes are understandably contentious, and it is impossible to handicap how members of Congress would vote on hypothetical legislation.

That said, we know that there is a combination of curiosity, fear, and uncertainty when substantial tax hikes are proposed. At Summitry, we consider after-tax wealth planning a crucial part of the planning process. In order to best serve our clients, we dove into the White House’s official press release around the Biden tax plan and identified some groups of individuals likely to be affected.

Who the Biden Tax Plan Affects

HIGH EARNERS

“Finally, high-income workers and investors generally pay a 3.8 percent Medicare tax on their earnings, but the application is inconsistent […] The President’s tax reform would apply the taxes consistently to those making over $400,000 […]”

High-income earners already pay a 3.8% Medicare payroll tax on wages (2.9% base Medicare payroll tax plus 0.9% for high-earners) on a lower amount of income than $400,000. Net investment income (NII) tax  of 3.8% also kicks in at a lower level.  Therefore, it is not entirely clear what income would be subject to additional tax, but we stay vigilant for future details.

“The President’s plan restores the top tax bracket to what it was before the 2017 law, returning the rate to 39.6 percent […]”

This change would restore the pre-2018 rates for the highest federal tax bracket, affecting couples who claim married filing jointly (MFJ) with income in excess of $628,300, and single filers earning $523,600.

HOUSEHOLD INCOME OVER $1 Million

“Households making over $1 million […] will pay the same 39.6 percent rate on all their income […]”

Households with income over $1 million (presumably for MFJ couples) will face a substantially higher bill on tax-advantaged forms of income, such as long-term capital gains and qualified dividends. In this scenario, the long-term capital gains rate would increase from 20% (23.8% including net investment income tax) to 39.6% (or 43.4% with NII tax).

This creates a significant incentive for those who expect income over $1M in any single year to consider the optimal timing for the recognition of income – an incentive that does not currently exist at the Federal level.

ANYONE GIVING OR RECEIVING AN INHERITANCE

“The President’s plan will […] [end] the practice of “stepping-up” the basis for gains in excess of $1 million ($2.5 million per couple when combined with existing real estate exemptions) and making sure the gains are taxed if the property is not donated to charity.”

This proposal is slightly less definitive, especially the reference to “existing real estate exemptions.” The numbers indicate these “exemptions” may refer to the Section 121 exclusion, commonly referred to as the “home sale exclusion.” This exclusion applies to the sale of an existing primary residence, under which eligible taxpayers can exclude $250,000 ($500,000 for a couple MFJ) of capital gains from the sale of a primary residence.

The “step-up” in basis is relevant to anyone who will receive or provide an inheritance; however, the effect is likely to skew with age. Baby Boomers and members of the Silent Generation may hold highly appreciated assets with the intention of receiving a higher basis for their heirs. If this is no longer the case, these generations may be inclined to adjust their lifetime sale and gifting strategies.

For Generation X and Millenials, inheritance may be slightly more complicated. Beneficiaries will have to consider the tax consequences of inheriting certain assets and their embedded capital gains. Additionally, as is the case with estate tax, inheritors may face the situation of trying to pay a tax bill with illiquid assets (e.g., private company stock, real estate). It is important, however, to note that the following language is also included in the White House Fact Sheet:

“The reform will be designed with protections so that family-owned businesses and farms will not have to pay taxes when given to heirs who continue to run the business.”

ALTERNATIVE ASSET MANAGERS

“[…] permanently eliminating carried interest is an important structural change.”

Carried interest, commonly referred to as “carry,” are profits accruable to investment managers in excess of their initial contribution to a partnership. Practically, it is a performance fee primarily received by general partners of an investment partnership. While carried interest is not nearly as prevalent as other forms of income, it serves as a political lightning rod due to (a) its preferential tax treatment relative to other forms of income and (b) its relative confinement to certain high-earning areas of asset management.

This change would primarily affect general partners and other investment managers who receive carried interest as part of their compensation. Presumably, any income derived from carried interest would be classified as ordinary income. Carried interest also benefits from postponing taxation until the gain is realized, not when it is recognized. In addition to a higher tax rate, carried interest may be taxable in the year received – although this is far from clear at this point.

REAL ESTATE INVESTORS

 “The President would also end the special real estate tax break—that allows real estate investors to defer taxation when they exchange property—for gains greater than $500,000.”

This passage falls squarely on real estate investors and the oft-used Section 1031 exchange. This section of the Internal Revenue Code allows (primarily) real estate investors to make a “like-kind exchange” of property without incurring taxes. An eligible taxpayer has the ability to execute a simultaneous purchase and sale, transferring their previous cost basis to the new property without taxation.

While Section 1031 exchanges do not apply to primary residences, real estate investors often use a combination of 1031 exchanges and the step-up in basis in the morbidly-named “swap ‘til you drop” strategy. This change would almost exclusively affect holders of investment real estate, primarily those with low basis properties.

BUSINESS OWNERS

“ […] the President would also permanently extend the current limitation in place that restricts large, excess business losses […]”

Again, this is slightly less clear, but this passage appears to refer to the dollar-loss limit for net operating losses passed through to an individual tax return. Introduced as part of the Tax Cuts and Jobs Act of 2017, it placed limitations of $500,000 loss pass-through for a couple (MFJ), or $250,000 for single filers. This would be an extension of an existing provision introduced in 2018, but that is currently set to sunset in 2025. This would apply primarily to business owners.

When Changes Based on the Biden Tax Plan Could Take Place

Now let’s talk about you. Namely, let’s discuss how the Biden plan affects you, what you should do, and when you should act.

Tax changes are always met with feelings of discomfort and urgency, often exacerbated by the concern, fear, and frustration of those affected. While all of these reactions are understandable and valid, the first and most important message we want to convey is: do not panic. It is not in your best interest to act quickly or rashly, to make decisions without the proper considerations ahead of time, or to forego conversations around long-term planning and the ramifications of actions taken today.

One note before continuing: You’ll notice we do not discuss possible market reactions to a change in tax law. While that discussion is worth having if you’re concerned, it’s a separate topic. What we will say is this: there is no proven correlation between tax hikes and market downturns, and in fact, it’s often the opposite. The same message applies here: do not panic. In the immortal words of Warren Buffet, “never bet against America” – we do not believe it is the time to suddenly pull your investments out of the market. Instead, have a conversation with your Summitry Advisor about your concerns and the effect of volatility on your financial plan, and work with them to determine appropriate next steps.

Resuming our tax discussion, when discussing recommended actions, we need to consider several things:

1 –  All of these ideas for policy change are just that: ideas. The version of policy that finally makes it out of Congress may look different in many ways from the verbiage stated in the AFP. Any action taken today may be rendered ineffective, redundant, or unnecessary by a later version of this tax plan. In simple terms, hastily made decisions to act or sell may result in tax payments we later find out were avoidable.

2 – Historically, tax changes are relatively commonplace. For example, capital gains rates have changed nearly 20 times over the past 50 years. So, in addition to the lack of clarity around what version of the AFP will make it through Congress, we also don’t know how enduring those changes will be. Again, what has changed before may change again, and action now may result in potentially avoidable tax payments.

3 – Both Federal and State governments can enact tax change in different ways. When changes in tax law are passed, they may take effect January 1^st of the following year, they may take effect immediately or fairly soon after being voted in, or they may take effect retroactively. If retroactive, the changes could encompass the entire tax year or could be written in a way that states that the law is effective from the time the public was first made aware of the proposed changes. Essentially, you cannot outrun the clock; you could be held accountable for actions taken in the time between now and the passing of legislation.

4 – There are still tools and strategies available. It’s true that these ideas are largely aimed at closing the legal loopholes that exist for high-income earners and recipients of windfalls. However, there will likely be areas untouched by any proposal, such as charitable donations, education funding, annual gifts, etc. We think leveraging tools like Donor Advised Funds and 529 plans, in conjunction with strategies like multi-year gifting, could make a powerful positive impact on your tax return.

5 – You are building a multi-decade plan. While the Biden tax plan policy ideas may feel weighty and significant, it’s important to put them in perspective. You may speak with your Financial Advisor and decide to make a change, but you also may determine that in the context of your long-term plan, the actions available to you today are not appropriate in relation to your goals.

Ultimately, our advice is this: If you fall into one of the categories mentioned above (or if you think you might in the future), make an appointment with your Summitry Advisor. We will take an in-depth look at your situation and discuss the positive and negative consequences of the options available. Our guidance will differ with each client, depending on unique demographics and goals, since these tax changes have the potential to affect individuals very differently.

We offer several services that will prove extremely helpful as we navigate tax changes in the coming months, including:

• Creation of long-term financial plans
• In-depth tax review and future-facing tax plans
• Estate plan review and referral to attorneys where necessary
• Collaboration with your other specialists (CPAs, estate attorneys, etc.)

We urge you to fully leverage our robust planning offering to ensure that you understand the proposed changes and the effect they may have on your individual plan. Most importantly, please lean on your Summitry team for the support you need in exploring your options and making these decisions; that’s what we’re here for and we’re eager to help.

 

Note: Summitry is not an accounting firm and tax decisions should be made in conjunction with clients’ accountants. Summitry opinions are based on preliminary information and subject to change without prior notification.