The greatest tax loophole of all time is a secret – or at least it might as well be since so few people know about it.
It is a safe bet that the vast majority in Congress are unaware of it, even though it is written into the tax code in plain sight, (Code Section 1014(b)(6)). The Greatest Tax Loophole of All Time allows you to sell assets for millions (even billions if you’re rich enough) without paying a penny in federal income tax.
Stocks, bonds, real estate, closely held business, and virtually any other assets sold at an otherwise taxable gain are immunized from federal income tax by the Greatest Tax Loophole of All Time. There’s only one catch – Somebody you love must die.
Most people have heard the cliché that the only certainties in life are death and taxes. What they haven’t heard is that death can be a great tax move. Take for example, The Greatest Tax Loophole of All Time, which is a tax anomaly referred to in the trade as “Double Step Up in Basis”. It applies to surviving spouses in community property states-including California.
Double Step Up in Basis means that for federal income tax purposes, when a couple is married in a community property state and one spouse dies – all of their community property is revalued to its fair market value as of the date of death (or six months thereafter) for purposes of determining taxable gain or loss on the sale of the property. This means that any increase in the value of the property during the life of the deceased spouse escapes taxation.
For example, suppose you and your spouse purchased stock in XYZ Company in 2002 for $40,000. The stock hits it big when on December 23, 2016 it is announced that a company patent has been approved, and by January 5, 2017, it has a fair market value of $4 million. When your spouse hears the news, he becomes so excited that he has a heart attack and drops dead. His last words to you with his dying breath are: “Sell!”
Normally, you would have to pay tax on the difference between the $4 million sales price and the $40,000 purchase price of the stock. As of the date of this writing, the top federal tax rate on long term capital gains is 20%.
Assume that you sell all of the stock on January 5, 2017. Without the double step up in basis from the death of your spouse you would owe $792,000 in federal capital gains tax, assuming the 20% rate applies across the board.
If the community property state you live in happens to be California, you can add approximately $495,000 in state income tax to the tab. All together the combined federal and state tax bill on your once in a lifetime stock windfall almost comes to a whopping $1.3 million dollars.
That’s the scenario if you and your spouse sell the stock while you are both still alive. The double step up rules completely let the air out of this tax balloon.
This is because after the death of the first spouse the stock for income tax purposes is revalued to its fair market value at the date of death (or six months thereafter if so elected). In the above scenario this means that your original investment in the stock is considered to be 4.0 million rather than just $40,000. If your investment in the stock is $4 million due to the double step up in basis rules, and you sell it for $4 million, your net gain is zero.
Zero gain means zero tax. It’s that simple. Likewise, suppose your client sells the stock at some point in the future after it had appreciated to 4.1 million, your taxable gain would be $100,000, since that is the difference between the value of the stock for income tax purposes (4.0 million) and the sales price (4.1 million). You would then pay Capital Gains tax only on the $100,000 profit, assuming there were no other offsets, such as business or capital losses.
The double step up in basis principle applies to all community property (included in the estate of the deceased spouse) regardless of the original purchase and ultimate sales price. If the stock is sold for $1 billion dollars after the death of the first spouse and the original purchase price was $10 dollars – as long as the double step up rules applied, the surviving spouse could skip off without paying so much as a dime in income tax on the gain.
There is more yet to come from this orgy of tax savings. Not only are assets revalued to fair market value for purposes of eliminating the tax on their sale – but if the assets are used in a trade or business, they can be revalued and deducted as a business expense via depreciation.
Suppose you had a machine worth $1 million dollars that was used in your trade or business that had been fully deducted through depreciation prior to the death of the first spouse. After the death of the first spouse it could be depreciated all over again to the tune of $1 million dollars.
Assuming the machine qualified as 5 year property – that would be $200,000 (averaged) a year in depreciation tax deductions. Assuming you were in a combined federal and state top tax bracket of 45%, this little tax move would save you $90,000 a year for 5 years. That comes to a total tax savings of $450,000. This concept also applies for Real Estate depreciation deductions.
This second bite of the depreciation apple, combined with the elimination or reduction in capital gains tax for assets sold post death is what makes the double step up in basis rules truly the Greatest Tax Loophole of All Time – but remember, it’s a secret!
About David Ellis CPA
David Ellis is the managing partner of Ellis & Ellis, CPAs, Inc. located in Pasadena, California. He has over 30 years of experience in the practice of Divorce, Trust/Estate, and other family tax matters