January 30, 2015

Trust Fund Loophole - Stepped-up Basis

During President Obama's recent state of the union address, he proposed, amongst other tax recommendations, to "close the trust fund loophole." The trust fund loophole he was alluding to is the "stepped-up basis" assets receive when a person inherits them.

The term "trust fund loophole" is a slight misnomer because all inherited assets receive a stepped-up basis. If a person dies with neither a will nor a trust, their heirs nonetheless receive a stepped-up basis for the assets they inherit from the decedent. There is no requirement that assets be held in trust in order to receive a stepped-up basis. Many past clients have been beneficiaries of an estate where the decedent did not have a will or trust. Presumably "trust fund loophole" was used for messaging reasons because tax terminology is regularly obscure and dull. 

The stepped-up basis, as presently constituted, works as follows. (this example is a hypothetical). In 1980, John Smith purchased a home in the Almond Grove district of Los Gatos, CA for $100,000. In 2010, Mr. Smith wrote a trust and funded the trust with his property by executing and recording a grant deed with Santa Clara County. In 2015, Mr. Smith passed away in a tragic hot air-balloon accident. The successor trustee then had the property appraised for $1M. If the property is sold by the successor trustee for $1.1M, the capital gains tax is generally on the $100,000 gain. The reason is that when Mr. Smith passed away, the property received a new basis that is pegged to the value of the property on Mr. Smith's death, i.e. $1M. See IRC § 1014. For example, if Mr. Smith passed away on January 15, 2015, the reference point for the appraisal of the property would also be January 15, 2015.

President Obama's proposal is to eliminate the stepped-up basis. Under this scenario, the sale of Mr. Smith's property would result  in a capital gains tax on the $1M gain. The reason is that there is no stepped-up basis, so the selling basis is the same as Mr. Smith's acquisition basis, $100,000. Hence, all the appreciation in Mr. Smith's home which previously escaped taxation would now be taxed. 

This blog offers no opinion on the strengths and weaknesses of this proposal. This post is strictly for informational reasons. Please do not contact me with your political viewpoint(s) on the matter. I am not affiliated with Congress. Thank you.