Obama Aims To Tax The Rich On Inheritance Assets By Ending The Trust Fund Loophole

NEW YORK (MainStreet) — Heirs have traditionally avoided taxes on any post-mortem increase in the value of a deceased person's investment portfolio assets; however, in his State of the Union address last month, President Obama proposed ending this provision known as the step up in cost basis law. That could pose costly consequences for those expecting hefty trust funds that aren't eroded by the IRS. 

“Right now, heirs are able to rebalance their inheritance or cash without having to pay for long-term capital gains,” said Michael Solari, CFP with Solari Financial Planning in Bedford, N.H. “If the step up in basis went away, then they either sit on the account or make trades incurring taxes.”

As it currently stands under the step up in cost basis law, a federal estate tax rate of 40% is levied on the estate that conveyed the portfolio assets only if the estate is subject to an estate tax. The capital gains are safe from the tax man.

Under the new proposal, capital gains tax on inherited assets would exempt only the first $200,000 for a married couple and $100,000 for singles; what's more, an heir might have to calculate depreciation or improvements of an asset using records from the decedent's estate.

“It is a potential accounting nightmare,” said Jason Smolen, principal with SmolenPlevy, a law firm in Vienna, Va. “You would have to know what the decedent paid to acquire an asset to determine the original costs basis for all inherited assets.”

That capital gains tax is 20% of the gain for estates that exceed the exemption.

“But there also are proposals to increase that to 25%,” Smolen told Mainstreet. “To that, you add 3.8% for those who earn more than $500,000.”

The Consequences and Life Insurance Boom

The elimination of the step up provision is expected to result in an uptick in using life insurance policies as an estate planning tool.

“If cash is used to buy more insurance, then heirs will receive a lump-sum of cash with no taxes,” Solari told MainStreet. “This is a great way to supplement an individual’s bond portfolio, especially for high-income earners.”

For example, the cash value that builds up tax deferred in a no load guaranteed universal life policy could be an alternative, because policies are guaranteeing 3% and paying a dividend from 4% to 5%.

“Insurance can be an add-on benefit that can reduce the frictional cost of taxes, especially if it provides liquidity when real estate or an operating business is a substantial part of the estate,” Smolen said.

In Theory...


At this time, the elimination of the step up provision, however, is merely a proposal.

“It requires Congressional approval,” Smolen said. “And that is going to be an uphill battle with the Republican controlled Congress.”

When and if the step up is eliminated, like-kind exchanges through Section 1031 of the tax code will likely become prevalent. A like-kind exchange allows for the sale of one asset in favor of another without generating tax liability from the disposal of the first asset.

“Planners like me are also likely to help their clients do more lifetime gifting, which could lead to a revival of the family LLC/family limited partnership model and annual exclusion gifting for even more modest estates,” said Donald H. Sienkiewicz, an attorney in Milford, N.H.

The annual gift exclusion per individual is currently $14,000.

-Written for MainStreet by Juliette Fairley

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