Archive for January 2015

President Obama to take on “trust-fund loophole”

In his State of the Union address, President Obama will, according to a report in the New York Times, propose what his advisors are calling the “trust-fund loophole”, in order to help finance tax cuts for the middle class.

Very interesting. My practice does not involve “trust fund babies” but rather the same middle-class people the President is seeking to benefit. And it is often middle-class people who are the direct beneficiaries of this “trust-fund loophole”.

Let’s first look at what this “loophole” is and and how it works. Suppose a parent gave an adult child the home which the parent purchased in the 1960s for $10,000. Further suppose that when that parent dies that same house is worth $150,000.

When the adult child sells the parent’s home, she will realize capital gain in the amount of $140,000. This amount is the difference between the price at which she sells it – $150,000 – and the parent’s “tax basis” of $10,000. Because the parent gave the property outright during the parent’s life, the adult child received this “carry-over basis” of $10,000.

Now imagine same parent, adult child and house in a different example. Instead of giving the property to the adult child outright during the parent’s lifetime, the parent instead gives the property to the adult child following the parent’s death through a will, trust, life estate deed or other device through which the parent retained certain rights over the house. In that case, the child would receive a “stepped –up basis”–meaning a cost basis equal to the value of the house at the time of the parent’s death.

So we have a very different result. In this case the child’s gain on the sale of the property would be equal to the $150,000 sales price, minus the $150,000 “stepped-up basis” or zero. Zero as in zero capital gains tax to the adult child. Versus $140,000 in capital gains tax in the “carry-over basis” example.

This is the “trust fund loophole” that President Obama seeks to close. The New York Times story quotes administration officials as stating that the tax “would fall almost entirely on the top 1 percent of taxpayers” and “would apply to capital gains of $200,000 or more per couple”.

We’ll see. In the meantime, it’s interesting to see how the term “loophole” can mean different things to different people.

Stealth Capital Gains

Many elderly (as well as non-elderly) clients have brokerage accounts which include mutual funds.  Many of my clients who have these funds (like perhaps the most of the rest of us) may do nothing more than open the monthly statement from the brokerage firm and glance at the results.  Though there are exceptions, most clients whom I have encountered are not active traders of these mutual funds.

Nevertheless, as Jason Zweig points out in a recent Wall Street Journal article, some of those people will be receiving IRS Form 1099s later this month showing capital gains distributions from the mutual fund which they held. How can this be when the investor did not sell any portion of the fund during the year?

The answer is that is while the account holder himself may not have sold any portion of his fund, the manager of the mutual fund did.  For example, managers of mutual funds who invest in stocks may have concluded that, as a result of the gains in the stock market in 2014, it was a good time to sell certain individual stocks within the mutual fund.  Because the stock was purchased by the manager at a lower price than at which it was sold–generally a good thing–this will result in capital gains to the fund. And as Jason Zweig points out:

“Mutual funds are generally required by tax law to pay out all profits they realize on the sale of their holdings.  An investor outside a retirement account is typically liable for taxes on any gains the fund distributed during the tax year – even if he or she never sold a share of the fund.”

The last part – outside of a retirement fund – means outside of a so-called qualified retirement account such as an IRA, 401k or other tax-deferred account. Investors in these types of accounts will generally not be liable for the capital gains of the fund in the year in which they were incurred.

For those holding mutual funds outside of these tax-deferred accounts, however, the end of January may contain in the mail a notice that such gains were incurred and need to be accounted for in determining potential 2014 income tax liability.

This post first appeared on the Long Term Care Planning Blog on January 5, 2015.