Strategic Communications and Marketing News Bureau

The President’s call to reform taxation on capital gains

In the State of the Union address, President Barack Obama proposed closing the so-called “trust fund loophole.” Richard L. Kaplan, the Peer and Sarah Pedersen Professor of Law at Illinois, is an internationally recognized expert on U.S. tax policy. In an interview with News Bureau Business and Law Editor Phil Ciciora, he discusses President Obama’s idea for reforming the taxation of capital gains.

What is the “trust fund loophole”?

That is a catchy phrase for a longstanding tax-code provision that has very little to do with trust funds but instead applies to many people who inherit property other than cash. This provision allows the new owner to reset his or her “basis” in the property to its fair market value when the previous owner died. It is typically called the “step-up in basis” rule.

For example, let’s say that a relative passes down stock that cost $2,000 but is worth $10,000 at the time of death. When the heir sells this stock, the IRS would measure gain or loss from $10,000, not $2,000. So if the stock is sold for $11,000, the taxable gain is $1,000 – the difference between the sale price and the “basis” of $10,000. The difference between what the relative paid for the stock and its value when it was passed down – $8,000 – is ignored for tax purposes.

Under President Obama’s proposal, the $8,000 gain that accumulated prior to the relative’s death also would be taxed when the stock is inherited.

Why does the step-up in basis rule exist in the first place?

This provision was put in to avoid double taxation when inherited property is subjected to the federal estate tax. But the exemption from that tax is now almost $5.5 million per person, so the vast majority of inheritances no longer owe any estate tax.

Would everyone who inherits property be affected by the president’s proposal?

Not quite. President Obama’s proposal would allow up to $200,000 of pre-death gain on inherited property to be exempted, plus up to $500,000 of such a gain on an inherited residence. Those numbers are for a married couple, and the exemptions for unmarried persons would be half of those amounts. In addition, taxes on small, family-owned and operated businesses would not be due until those businesses are sold.

Has the step-up in basis rule been targeted for repeal before?

Yes. It was effectively repealed in 1976, but the outcry following that change was so widespread that Congress reversed the repeal retroactively. President Bill Clinton also proposed repealing the rule during his first few months in office. The reaction then was swift and negative, and the proposal was dropped.

How likely is it that it will be repealed this time?

Providing six-figure exemptions, as President Obama has done, takes the sting out of this proposal for many people, but the step-up in basis rule has been in the law for a very long time. Repealing it would be a heavy lift even in a Democratically controlled Congress, as President Clinton’s experience demonstrated. However, it could eventually resurface as part of a major tax overhaul effort that affects numerous provisions and various constituencies.

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