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.

Property Taxes and Capital Gains

The notable Campbell, CA water tower down the street from my office

When somebody inherits real property and sells it thereafter, two important legal issues commonly arise, property taxes and capital gains. Property taxes in California are governed by Prop 13. Basically Prop 13 says that real property may be levied a 1% tax on the assessed value each year and the assessed value may be raised by no more than 2% annually. Capital gains is the tax imposed on a person when an asset is sold for a gain, namely the sale price exceeds the cost-basis. The following example illustrates how these legal topics relate to inheriting and then selling real property in California. 

The following individuals are fictitious characters invented through the limited powers of my imagination.

In 2008, Bobby Beneficiary, a resident of Mendocino, CA was informed by his Uncle George that his mother Ma Bell passed away and left her home in Campbell, CA to him through her will. Bobby's father Pa Bell had predeceased his mother. Ma and Pa Bell bought the home in 1980 for $10,000. Later in 2008, the will was probated and title to the Campbell home was transferred to Bobby from his late mother. Bobby was concerned that he will have to pay property taxes for the current value of the home, $600,000. However, Bobby was told by the probate attorney that this transfer qualifies for the parent-child exclusion and no re-assessment for property taxes will occur. Rev & T C § 63.1. Thus, Bobby was able to maintain the very low assessed value of the home, $10,000, for as long as he desires. This was particularly important for Bobby because he would rather not be forced to sell the property. Instead, Bobby would prefer to sell the property during a seller's market.

A few years later, in 2011, Bobby decides that the time is right to sell the Campbell home. Bobby was able to delay the selling of the home because property taxes were quite affordable given the low assessed value of the home. During the summer of 2011, Bobby finds a purchaser of the home and the parties agree to a purchase price of $650,000. Following the sale, Bobby becomes concerned over the enormous tax burden he will face next year when he files his taxes. The reason for Bobby's concern is that he has received shoddy accounting information over the years. Bobby has been deceived into believing, through viewing many late-night infomercials, that his basis in the property is $10,000. Hence, he erroneously believes that he will have a gain of roughly $640,000 (650,000-10,000). Yet in reality when Bobby inherited the property from his mother he received a new cost-basis in the property. When a person inherits property, the cost-basis is generally the date of death value of the asset.  IRC §1014(a); Rev & T C §18031. Here, the value of the Campbell home was $600,000 on Ma's date of death. Thus, Bobby's capital gains would in actuality be much smaller than he originally believed. That is, his capital gains would be $50,000 (650,000-600,000). Ultimately, Bobby's ability to inherit property from his mother, known as stepped-up basis, reaps enormous tax savings for him.

As you can see, inheriting property from somebody enjoys the best of both worlds, retention of old assessed value for property tax purposes and a stepped-up basis for the asset to reduce capital gains.

Stepped-Up Basis

Whenever a person sells an asset, whether personal or real, the person needs to determine cost basis of the item to ascertain whether or not the sale results in a taxable gain. For example, John purchases 118 Green Street in CA for $100,000 in 1985. The cost basis would be $100,000. If, generally speaking, John ever sold the property for greater than $100,000 such sale would result in a taxable gain.

One of the prime benefits of acquiring real property through inheritance is the application of "stepped-up basis." The result of stepped-up basis is that a person who inherits real property receives a new cost basis which is pegged to the fair market value of the asset at the date of the decedent's death. IRC §1014(a); Rev & T C §18031. Yes, that is how it is written in tax terminology. For example, from above, John purchases 118 Green Street for $100,000 in 1985. Due to real estate appreciation (just go with it), John's home gradually increases in price to $700,000 in 2012. John then dies in a tragic hot air balloon accident in 2012 in Morgan Hill, CA. John's heirs would be entitled to claim $700,000 as the cost basis of the home. Subsequently, when John's heirs sell the home, the starting point for a taxable gain would be $700,000, whereas the starting point for John would be $100,000. Though capital gains tax is much lower than regular income tax (see Mitt Romney tax return for 2010), it still is roughly 25% combined for federal and state, that is California. When you multiply that by 600,000, the result is a rather large number. Thus, it is quite clear that stepped-up basis affords heirs an enormous tax savings because they are not liable for the appreciation that has accumulated over the years. Rather, the heirs can take advantage of the new date of death value of the asset. The common result is that heirs of real property often pay little to nothing in capital gains taxes if they sell the inherited property shortly after receiving it.