Which Classic Tax Strategies Are At Risk In A Democratic Congress?

You may be counting on the step-up, Roth conversions and donor-advised funds. But politicians could snatch these goodies away.

Billionaires are the first targets of tax hikes. You’re next.

Take a close look at the tax plan in the budget proposal that came from the White House last week. It probably won’t be enacted, at least not in its present form. But it is a window into the wish list of tax reformers. They aim to kill off a long list of tax avoidance strategies as soon as they get the votes. If not this year, then maybe three years or five years from now.

The so-called billionaire tax, which would levy a 20% rate on both the income and the wealth gains of very rich people, is the most visible part of President Biden’s plan. It turns out that this would apply not just to billionaires but to anyone worth more than $100 million.

It is a threat, moreover, to people with much less money. Why? Because it’s an opening wedge. It introduces the notion of taxing paper gains—wealth increments, that is, that are unaccompanied by realized income. Once this becomes a way of taxing people, some future Congress, hungry for federal revenue, could easily lower the starting point from $100 million to $10 million or even $1 million.

Besides the “billionaire” wealth tax, the Biden budget asks for a boost in the top rate from 37% to 39.6% for taxable incomes above $450,000 on a joint return. It includes a crackdown, applicable at all income levels, on estate-planning strategies involving “grantor trusts.” It nibbles away at donor-advised funds, charitable vehicles used by prosperous taxpayers. It limits the value of depreciation deductions taken by real estate investors.

Whether Biden can get any of this through a closely divided Senate is an open question. It hangs on the votes of two on-the-fence Democrats, Joe Manchin of West Virginia and Kyrsten Sinema of Arizona. Manchin appears willing to sign off on some tax hikes but not the taxation of paper gains. Sinema is hostile to tax increases except at the upper reaches of the income spectrum ($10 million and up).

But there’s a lot of Democratic support for a broad-spectrum attack on “loopholes,” which can perhaps be defined as anything that helps taxpayers hang onto money they have earned.

One such hole in the tax code is the step-up, exempting from income tax (but not estate tax) the appreciation in assets held at death. An early version of last fall’s failed Build Back Better bill would have drastically limited step-up at death. The version that finally passed in the House, but not the Senate, omitted that law change but did a lot of other damage. It attacked large IRA balances, expanded the coverage of the 3.8% investment income tax and added new tax brackets for very high incomes.

I asked two tax experts who track the goings-on in Washington to handicap the risk level for various tax changes that would damage savers: Bill Smith of CBIZ, a national accounting and financial advisory firm, and Timothy Laffey of Rockefeller Capital Management, which provides investment advice to wealthy families.

Neither is an alarmist. They put fairly low odds on enactment this year of most loophole closers. But they agree that investors need to be sensitive to the long-term political pressure for eliminating tax maneuvers used by the well-off.

If there’s any tax bill enacted this year, Laffey says, there’s a good chance it will include: an increase in the 21% corporate tax rate; an increase in individual income-tax rates but only for very high incomes, and a rule treating financiers’ carried-interest fees as ordinary income.

What about the long term? Below is a survey of a dozen tax strategies used by people who accumulate capital. Some strategies are safe. Some are at risk. You should factor the odds of a law change into your planning.

If you do that, you might revise an estate plan that hinges on the step-up. You might scale back whatever arithmetic now dictates maximizing tax-deferred retirement saving. You definitely should revisit any presumption that your tax bracket will go down in retirement.

Step-Up

The reformers are right about this one: It’s a loophole. There’s no economic reason for exempting appreciation from income tax just because the owner of an asset died holding it.

An early version of the Build Back Better fill would have limited the step-up to $1 million. That ceiling may be too low to get through Congress, says Rockefeller Capital’s Tim Laffey. It would mean that heirs to a modest IRA and a suburban home could get a surprise income-tax bill.

Laffey predicts that if and when Congress lowers the boom on unrealized gains it will grant a $5 million exemption that is portable, meaning that a couple could pass on $10 million of appreciated property to their kids.

Any curbing of the step-up would likely apply, again with a generous exemption, to gifts as well as bequests. It’s a toss-up whether a tax reform will treat a transfer as a sale or, instead, merely require the recipient to take on the historical cost basis.

What you should do about this: Hang on to highly appreciated property and keep your fingers crossed. If your will has both relatives and charities as beneficiaries, make sure the executor has the flexibility to dump toxic assets on the charities.

Depreciation

Let’s say you buy a $1 million apartment building and claim $36,000 a year in depreciation against it, lowering your ordinary income from rent by that amount. After ten years you sell the building for $1.8 million. Under present law you’d declare $800,000 of long-term capital gain taxed at a favorable rate (up to 23.8% federally) and another $360,000 of Section 1250 depreciation recapture taxed at a somewhat favorable rate (28.8%).

The Biden budget wants the recapture taxed as ordinary income (up to 37% now, or 39.6% when the Trump tax cuts expire). This kind of reform could definitely happen, either now or down the road. CBIZ’s Bill Smith calls this a “medium” risk.

What to do: Be less enthusiastic about syndicated real estate deals.

Grats

Grantor retained annuity trusts keep many a lawyer busy. You deposit into the trust an asset with appreciation potential, then take back an annuity of a certain dollar amount. When the annuity is over with, the asset goes to your descendants. If the annuity is large, the remainder interest has a tiny present value, so you don’t owe much gift tax. If the asset performs, you potentially pass along millions of dollars without an inheritance tax. It appears that Mark Zuckerberg stuffed some cheap founder shares in Facebook into one of these things.

The Biden budget wouldn’t entirely outlaw Grats. But it would impose enough limitations, says Laffey, to make them pointless for most taxpayers. Since Grats are an unadulterated tax dodge they are at risk in any reform plan.

What to do: Get your trust paperwork ready now. Pray that new rules become effective only after a reform bill is signed into law. If and when such a bill heads to the president’s desk, pull the trigger.

Roth Conversions

With a conversion, you prepay tax on IRA money, making the account totally tax-free and, so long as you are alive or your spouse is, free of minimum distributions. Assuming you pay the income tax from money outside the tax-deferred account, the conversion is a modest winner if your tax bracket is destined to stay the same. It’s a big winner if your bracket is destined to go up, which will be the case for many people when the 2017 tax cuts expire at the start of 2026.

Loophole? Yes and no. That House bill called for denying conversions to taxpayers with more than $450,000 of taxable income on a joint return. But the effective date was going to be in 2031, which would have motivated rich people to do conversions in the meantime, showering the IRS with tax payments.

Evidently the legislators were inspired not so much by social justice as by their hunger for accelerated tax payments. I conclude that your right to convert is pretty safe.

What to do: Have in place a conversion game plan for the next four years. After that you can keep doing conversions but they will probably be somewhat less valuable.

Back-Door Roth

There are income limits on contributions to Roth accounts. Compulsive savers have been waltzing around these limits by making aftertax contributions to retirement accounts and then, at low or no tax cost, converting the accounts to Roth accounts.

Unlike the usual sort of conversion, which accelerates the movement of cash into the Treasury (see preceding section), the back-door schemes simply allow people to get a tax holiday on additional chunks of their portfolio. The House bill would have outlawed the practice at all income levels. Risk that the back door will be slammed shut someday, per Laffey: medium.

What to do: use the scheme while it’s still legal.

Giant IRAs

Populist anger attaches to the lucky few whose retirement accounts have ballooned. The House bill would have compelled fairly rapid liquidation of account balances over $10 million, beginning in 2028.

Risk that this kind of success will be punished: Low now, medium over the long term. For taxpayers who already have large tax-favored account values (say, over $5 million), the risk diminishes the desirability of using exotic techniques, like the back-door Roth cited above, to fatten IRAs.

Donor-Advised Funds

Fidelity invented this way to accelerate deductions for philanthropy. Its charitable gift fund, since copycatted by other brokers, disbursed $10.3 billion last year. You get a charitable deduction when you put money in, but can keep it invested and then dribble out grants over a period of years.

You can fund your contribution with appreciated property, taking advantage of another tax technique. Say you put $10,000 into Tesla or bitcoin and the stake is now worth $80,000. You donate it to the fund. If you’ve held the asset for more than a year, your charitable deduction is $80,000 but the $70,000 of gain is never taxed.

What’s not to like? Some would-be reformers want to mandate that the money go out to the end charity immediately. That would help charities in the year following a law change but would backfire in the long run. It would make people less generous.

Risk that Congress will strangle these babies: very low. The Biden plan proposes only a modest change. It would limit the ability of private foundations to use donor funds to duck the requirement for minimum disbursements to operating charities.

What to do: Take advantage. By planning your giving around a donor fund, you can lump years of giving into a single year when you will itemize deductions. You might want to combine this move with a Roth conversion.

QCD

The qualified charitable distribution allows IRA owners, once they turn 70-1/2, to send money from the account to a charity. The distribution keeps this money out of your adjusted gross income, a great benefit. If you play your cards right (make the donation in a calendar year before taking out a distribution for yourself), the QCD counts toward that year’s minimum distribution. RMDs are required once you turn 72.

Risk that this giving option will be taken away: low. The $100,000 annual limit means that the tax dodge is meaningless to billionaires. Charities would suffer if Congress changed the law.

What to do: If you are old enough, use your IRA for your charitable giving. Laffey says that virtually all of his eligible clients employ this feature of the tax code.

Crypto Washes

The rule on wash sales says that you must postpone the capital loss deduction if you buy back an asset within 30 days of selling it. The rule applies to securities but not cryptocurrencies. The House bill would have extended the wash-sale rule to crypto and commodities.

There is a good chance that Congress will eventually get around to putting cryptocurrency trades under the same restrictions as securities trades.

What to do: Take advantage of the loophole while you can. If you have an underwater position in a crypto asset, sell it and buy it back. Wait at least a few hours (or, to be safe, a day) before reestablishing the stake.

Dynasty Trusts

In the early days of the federal estate and gift tax, rich folk would give or bequeath assets to grandchildren in order to avoid the tax that would have been imposed on the middle generation. Congress responded with a generation-skipping tax.

The GST was effective in part because, at the time, state law limited the duration of a trust fund. In recent years, however, several states have enacted statutes to permit long-lived trusts. It is now possible to fund a trust that finances generation after generation of high livers, with transfer tax imposed only once.

The Biden plan would end this game. CBIZ’s Smith rates the probability of an eventual reform as “medium.”

What to do: If you must create a perpetual trust, do it sooner rather than later. But don’t get your hopes too high. A new law won’t necessarily grandfather your trust into a perpetual GST forgiveness.

The $12 Million Exemption

The 2017 tax cut increased the federal estate/gift exemption to what is now, with an inflation adjustment, $12 million per estate, or $24 million for a couple. A sunset in the 2017 law will cut these numbers in half, beginning in 2026.

There was a brief Democratic effort last year to shrink the exemption, but it never got close to enactment. What’s the likelihood that Congress will revisit this topic? Low, says Laffey. “If you’re going after billionaires that change doesn’t do a whole lot.” If tax raisers ever get the votes it’s more likely, he says, that they will leave the exemption undisturbed but kick up the top estate bracket, now 40%.

What to do: If you have money you know you won’t need, consider using up your exemption in the form of a gift. You have less than four years before the exemption shrinks.

Reduced Rates For Dividends And Long Gains

Long-term gains and most dividends get a break: The maximum federal tax rate on them is 23.8%, including a 3.8% investment income surtax. Biden wants to end the preferential rate for taxpayers with million-dollar incomes. They’d have to treat gains and dividends as ordinary income.

Smith rates the likelihood of the Biden tax proposal as low. A future Congress could, however, take a more modest whack at coupon clippers. It would be easy to raise the 3.8% investment surtax to a higher number.

What to do: In selecting stocks, be a little less inclined to favor those with fat dividends.