In President Obama’s State of the Union address last week, he spoke of closing tax loopholes used by the wealthy. One of those “loopholes” that is in Obama’s gun sights is what the White House has dubbed the “trust fund loophole.” This is actually a misrepresentation because this “loophole” has absolutely nothing to do with trusts.
What the White House is calling the “trust fund loophole” is the step-up in tax basis rule. This rule applies to all assets you own upon your death, regardless of how they are owned. Your beneficiaries get a step-up in tax basis in all assets that they receive on account of your death, including those that you owned individually, jointly or in your trust.
But what is the step-up in tax basis rule and how is it calculated? Let’s say last year in 2014, you sold Dad’s home, which you received after Dad died in 2010. Dad originally paid $10,000 for the home in the 1960s, but you sold it for $130,000, for a gain of $120,000. However, your tax basis in the property would be the value of the home on Dad’s date of death.
If the home was worth $115,000 on Dad’s date of death in 2010, your tax basis is $115,000. When you sold it for $130,000 in 2014, you only have to pay taxes on a gain of $15,000. You are taxed only on the increase from the date of death value of $115,000, to the sales price of $130,000. The $105,000 gain from Dad’s original purchase price of $10,000 to the date of death value of $115,000 completely escapes all taxes. Great result.
If instead of the home being transferred upon Dad’s death, Dad gifted the property to you in 2002 by quit claim deed into your sole name, there would be a very different result. Your tax basis in the property would be the same as Dad’s basis in the home of $10,000. This is called carryover basis. When Dad’s home sold for $130,000 in 2014, you would then have pay capital gains taxes on the entire $120,000 gain. Bad result.
There is a special rule for gifted property you sell for a loss. Your basis is the lesser of the carryover basis or the fair market value on the date of gift. This prevents Mom or Dad from transferring the loss to you by gift.
A situation in which the step-up in tax basis rules confuse many individuals and tax preparers alike is joint ownership. If Dad added you as a joint owner of his home, there is a different income tax treatment depending upon whether the home is sold before or after his death.
If that joint property is sold during Dad’s lifetime, you and Dad would each report one-half of gain on the sale of the home using Dad’s original carryover basis. There typically is no step-up in basis for these types of gifts when they are sold during the original owner’s lifetime. Using Dad’s basis of $10,000 and a sales price of $100,000, you both would report $45,000 gain. However Dad’s gain would not be taxable if the home was his principal residence and he lived in the home two of the last five years.
On the other hand, if the joint property was not sold until after Dad’s death, you would receive a full step-up in basis of that home to the value on Dad’s date of death. You are taxed only on the increase in value from Dad’s date of death to the date of sale.
If the surviving joint owner contributed to the purchase or improvement of the joint property, there would only be a partial step-up in tax basis to the surviving joint owner. You would have to prorate the contributions of each joint owner in the property, and the step-up in tax basis would only be on that portion of the joint property contributed by the deceased.
The step-up in basis rule is a little different with joint ownership between a husband and a wife. For property that is held jointly by a husband and wife, each spouse is deemed to own one-half of the property, regardless of contribution. Upon the death of one spouse, the surviving spouse gets a step-up in tax basis in the half received from the deceased spouse and a carryover basis in his or her own half.
President Obama wants to eliminate the step-up in tax basis rule completely. In the President’s proposal, if any property of the deceased is sold after death, taxable gain would be calculated using the carryover basis. It would also be calculated and taxed upon death, like Canada, even if there was no sale. This would increase tax revenue. The increase in taxes would be necessary to fund all the new governmental spending programs the President has introduced in his State of the Union address.
But, to get the buy-in of the American public and to show that the proposal is only aimed at the wealthy, there are some exemptions. You would not have to pay taxes on the first $250,000 of gain on the sale of a principal residence ($500,000 if you are a married couple). In addition there is a proposed exemption on the first $100,000 of gain on the sale of other assets ($200,000 for a married couple).
What is the likelihood of the President’s proposal becoming law? I would not even venture to guess. It all depends on the Let’s Make a Deal attitude that seems so prevalent in Washington these days. As has happened in the past, if the Republicans in Congress want something, they will probably have to give something to the Democrats in the White House.
If the proposal does pass, it certainly will keep us lawyers and accountants busy. Maybe instead of calling the proposal the “trust fund loophole” closer, it should be called the “lawyer and accountant full employment plan”.
By: Matthew M. Wallace, CPA, JD
Published edited January 25, 2015 in The Times Herald newspaper, Port Huron, Michigan as: Closing loopholes will keep lawyers busy