President Biden announced the American Families Plan on April 28. In addition to outlining major investments and spending, he has proposed a few measures to fund the $1.8 trillion plan. The plan allegedly intends to generate the fund through raising taxes on top earners. However, some forest landowners could be adversely affected by some of the tax proposals in the plan. You may want to be aware of these proposals and watch the development closely.
What are the tax proposals in the plan that could affect family forest landowners?
- Increase tax rate on long-term capital gains. President Biden has proposed to increase the top marginal capital gains tax rate to 39.6% for households with annual income more than $ 1 million. When combined with the existing net investment income tax (3.8%), the capital gains tax rate for some high-income taxpayers would go up to 43.4%. This would almost double the current rate. Under current law, the top capital gains tax rate is 23.8%.
- Tax capital gains at death and eliminate the step up in basis. The president has proposed to tax unrealized gains on appreciated assets upon death and eliminate the step up in basis, with a $1 million exemption per person (or $2.5 million for married couples filing jointly when combined with the main home exemption) and several exceptions.
- Limit like-kind exchanges. President Biden has also proposed to tax 1031 like-kind exchanges with capital gains over $500,000.
How would these proposals affect forest landowners?
Income from timber sales qualifies for capital gains tax treatment for most forest landowners. The sharp increase in capital gains tax rate means a significant increase in taxes upon timber sales for some forest landowners, especially if they have a large timber sale in a year and additional income from other sources. The current plan says it only applies to households with income over $1 million. Hopefully, most family forest landowners would be protected by this income threshold limit.
Taxing the unrealized gain on appreciated assets and eliminating the stepped-up basis at death could mean a significant tax burden for the estate and the heirs. Timber and land almost always appreciate over time. Under current law, timber and land receive a step up in basis to its fair market value when the assets are passed on to the heirs. Later on, when the new owners sell the timber or land, they pay capital gain tax on the appreciation that occurred after the inheritance. Under the proposal, significant capital gains tax could be due upon the death of the previous owner. Some heirs may have to sell part of the property to pay the capital gains tax upon death. This problem could be especially acute for land-rich, cash-poor forest landowners. The timber market in the South has been depressed since the last great recession. It could take years of returns to equal that amount of the tax.
The present proposal has a high exemption, which may protect many family forest landowners from the tax. Moreover, the president says that farm and family business would be exempt from the tax if the operation would continue in the family. However, details are not released in the plan and other sources. A newsletter released by the USDA stated that the capital gains tax is deferred as long as the farm remains family-owned and operated and heirs continue to get the stepped-up basis on the first $2 million in gains. However, it is still not certain if forest landowners are covered even if this special provision is in place because managing forests is not consistently classified as farming under various sections of the Internal Revenue Code.
Forest landowners could be negatively affected by the limitation on like-kind exchanges. Many family forest landowners use this provision as a tax strategy to buy and sell timberland properties and defer the capital gains on the transactions.
What should you do?
No need to panic. It still remains to be seen how the tax proposals face changes in Congress. Under the current proposal, most family forest landowners could be well protected by the exemptions and income threshold. However, it is important for forest landowners to watch closely the development of the tax proposals and stay engaged in the discussion. If you have planned to sell timber in the upcoming a couple of years, you may consider communicating with your forestry consultants about current timber market.