How Much Will Closing Trust Fund Loophole Cost You?

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By Jason Notte

It's about to get a lot more difficult to inherit a tax-free fortune. That doesn't mean it isn't possible.

In his State of the Union Address, President Barack Obama proposed ending the "step up" provision in the capital gains tax -- which basically shields those getting an inheritance from capital gains accrued by those leaving money or property behind. Under the president's proposal, that provision would be eliminated entirely and expose those left behind to more tax liabilities.

"It would make it much harder to shield assets from taxes," says Jason D. Smolen of the Vienna, Virginia, SmolenPlevy law firm, describing the wide-ranging effects the change would bring to many families. "To do so would require a great deal more planning, and help from estate attorneys and accountants."

While the president says the closing of what he calls "the trust fund loophole" will ensure that the wealthiest Americans pay their fair share on inherited assets, Smolen says that term is a bit of a misnomer. He also notes that the proposal would affect more than just the rich, as any beneficiary would have to look up the original cost of just about any asset they inherit. It will not only cost them a chunk of their inheritance, but also a lot of time and money just sorting out the financial details.

New Threshold Proposed

Let's say, as Smolen does, that you bought GE stock 15 years ago for $500. If, at the time of your death, that stock is worth $2,500, that's a gain of $2,000 that you haven't paid tax on. Currently, if you leave those shares to one of your children, their cost basis would be $2,500. That means that whenever your child sells the stock, he or she will only owe tax on capital gains that build up over her $2,500 cost basis. Under Obama's proposal, however, any capital gains over $500 would be taxed.

It's a bit different for married couples. They can bequeath investment assets with capital gains up to $200,000 tax free. Also, if you bequeath your home to a child, $500,000 in capital gains would not be taxed. That's a considerable shield, but Smolen notes that for many families that still might not be enough to avoid a huge tax bill.

"For example, if you bequeath a family-owned business to your children that they are required to sell for various reasons, they face a large tax bill associated with the sale of the business, and that impacts estates and families that may have far less assets than the current federal estate exemption of $5,430,000," he says. "It is a broader-based tax."

Step Up Provision

That said, it isn't unavoidable. Smolen says that, without the "step up" provision, many beneficiaries would need to set up trusts to protect their assets from increased taxes. A donor can transfer assets to the trust, which would take them out of the tax picture. But Smolen says more couples may decide to sell their home instead of passing on a huge capital gains tax bill to their kids.

Also, the elimination of the "step up" could go a long way toward making the term "rich" vary widely by geography. If you're in a place with a high cost of living, capital gains can exceed those federal thresholds in a hurry and make it a whole lot more difficult for beneficiaries to take value from the assets you're leaving behind.

The president's plan is still a long way from reality, but its adoption will make estate planning a whole lot more complicated. Assets that were once well beyond the capital gains tax would be up for grabs, and a simple inheritance process might suddenly require the help of a financial advisor just to suss out the taxes on even minor investments.

"A lot of folks are going need professional advice to devise a smart strategy that maximizes what they are able to pass along to their loved ones," Smolen says. "Needless to say, I would be very busy."
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