Tuesday, January 20, 2015


Yesterday I told you what tax “reform” for the “middle class” that BO will be proposing in tonight’s State of the Union address.

Today I will tell you how he plans on having the “wealthy” pay for these expanded, and Code-complicating, tax expenditures.

Raise Top Capital Gains and Dividend Rates

BO wants to raise the top “special” tax rate on qualified dividends and long-term capital gains from 20% to 28%.

We are told that the current top tax rate on qualified dividends and long-term capital gains is 23.8% - 20% maximum capital gain tax rate plus the 3.8% Obamacare surtax on net investment income.  This is not true. 

For high income taxpayers who are victims of the dreaded Alternative Minimum Tax, especially those who live in highly taxed states like New Jersey, New York, and California, the effective tax cost of qualified dividends and long-term capital gains can be higher – almost 31%.   

While qualified dividends and long-term capital gains are also taxed separately, at the special capital gain rates, under the dreaded AMT, this income increases “Alternative Minimum Taxable Income”, and can decrease and eventually wipe out the AMT exemption amount – causing more “ordinary income” to be taxed at the AMT rate.

When I first started preparing 1040s, back in the early 1970s, there were no special “capital gains tax rates”.  However there was a 50% capital gain exclusion.  50% of all long-term capital gains disappeared from the tax return.  If your capital gain was $10,000 your Adjusted Gross Income and net taxable income was reduced by $5,000, and you basically paid tax, at regular ordinary income rates, on $5,000.  I think I prefer this concept to a special capital gains tax rate – although I will admit I very much like the current 0% tax rate.

I would gladly support doing away with a special reduced tax rate on dividends if, and only if, a “dividends paid deduction” was permitted for corporations.  I would also gladly support doing away with all special industry-based corporate tax “loopholes” – so that you were taxed on corporate book income less dividends paid. 

{Aside - I also support doing away with the corporate deduction for depreciation of real property – but that is the subject for another post.}

Eliminate Stepped-up Basis on Inherited Property

BO proposes to eliminate stepped up basis at death.  He calls the step-up in basis an “egregious” loophole, and “the single largest capital gains tax loophole”.  

When you inherit investments – stocks, mutual fund shares, real estate – your “tax basis” for reporting capital gain and loss on the sale of the investments inherited is the fair market value of the investments on the date of death of the person from whom you inherit the assets – or the fair market value 6 months after the date of death.  It is the value for the investments that would have been reported on the federal estate tax return if one had been filed.

If your uncle purchased 100 shares of XYZ corporation for $1,000 in the 1970s, and the stock is worth $11,000 when he leaves it to you, your “cost” is $11,000.  If you sell the stock once title has been transferred to your name for, say, $11,500 you have a taxable long-term capital gain of only $500.  If you sell the stock for $10,000 you have a $1,000 long-term capital loss.

{FYI - the sale of inherited property is always treated as long-term by the beneficiary regardless of when the deceased actually purchased the property or how long you held it before selling.}

Nobody pays any capital gains tax on the $10,000 increase in value (the stepped up basis) based on the original $1,000 purchase price.

Why does this happen?  To avoid double-taxation.  The $11,000 value of the stock would have been included on the federal Estate Tax Return of your uncle, and would have been taxed had there been a taxable Estate.

This was a lot more likely when the federal Estate Tax exclusion was $675,000 – but is truly rare today with the current $5+ Million exemption. 

If there was a taxable estate the Estate Tax on the $10,000 increase in value would be a lot more than the capital gains tax of 0%, 15%, 20%, or even 28%.

It appears to me (and correct me if I am wrong) that under BO’s proposal the capital gains tax on the increase in value would be assessed to and paid by the estate at the time of death.  The beneficiaries would still receive a “stepped up” basis (because the tax was already paid by the estate) and not have to pay the capital gains tax when they sell the property.

This would not affect the federal Estate Tax filing.  I expect the gain would be paid on a Form 1041, or perhaps a new 1041-CG, filed by the estate.  And the tax would be paid directly by the estate; the gain would not be passed through to the beneficiaries on a K-1.

It is unclear just how the appropriate capital gains tax rate – 0%, 15%, 20%, or even 28% -would be determined.  Perhaps it will be based on the deceased’s final 1040, or the last 1040 that covered a full calendar tax year.

Under this plan, if there is a federally taxable estate, say in the above example your uncle’s estate was worth $10 Million, there would still be a “double-taxation” on the increase in value.  Perhaps there would be an adjustment on the 1041-CG for capital gains that were taxed on the Form 706 (the Estate Tax return). 

As explained in “Obama Proposes New Tax Hikes on Wealthy to Aid Middle Class” by Richard Rubin and Margaret Talev at BLOOMBRG.COM –

The administration’s proposal on capital gains at death would exempt the first $200,000 in capital gains per couple plus $500,000 for a home {the current exclusion for gain on the sale of a personal residence on a joint return – rdf}, along with all personal property except for valuable art and collectibles. The rest would be treated for income-tax purposes as if it had been sold.”

And the proposal would also exempt inherited small, family-owned businesses from capital gains tax at death unless and until the business was sold. Any closely-held business subject to capital gains tax would have the option pay out over 15 years.

I have always been against totally eliminating the step-up in basis for inherited property.  It is one reason I have been somewhat hesitant to support “killing” the federal “death tax” (aka Estate Tax).  Eliminating the step-up in basis would create a nightmare for tax professionals.  It is hard enough to get clients to keep track of investments purchased during their lifetime, let alone what their parents or other relatives paid for property and investments acquired before they were born!   

This “loophole” benefits lower and middle income individuals just as much as it benefits the wealthy.

However, having the capital gains tax paid by the estate before transferring title to the beneficiaries is a better way of dealing with the taxes lost by stepped-up basis.  There would still be problems determining the cost basis, depending on when and how the investments were originally acquired by the deceased.  But a lot less problems than if we taxed the beneficiaries when they sell the investments.

If there is going to be an elimination of the stepped-up basis tax avoidance this is a better way to implement it.  It shows some actual thought by BO, or whoever actually came up with the plan, a true rarity when it comes to tax legislation.

Of course this is all academic.  BO’s tax proposals, both to help the middle class and punish the wealthy, will never pass in the Republican controlled Congress.


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