Don't Tax Me! Tax The Other Guy ...

     As we know, start-up farming is difficult these days.  After the Revolutionary War, the soldiers who survived and mustered out of the service were given land warrants for services rendered.  Public lands were used as pension grants. The old veterans got their land warrant which they sold for cash (providing the vets with a modest one-time pension).  Bankers bought the warrants and sold them with interest to young farmer-settlers in western states and territories. Young farmers got land to begin their farming life, and bankers made money.  Everyone got something.  That was "startup farming" in the latter part of the 18th Century America.

     The Obama Administration, in the 2015 State of the Union message, hinted at the opposite sort of change.  The Obama folks with changes in the capital gains tax system for estates would make inheriting the farm even more difficult and costly. 

     When someone dies and wills the heirs property, those inheriting anything but cash property, especially real estate or stocks and bonds, get a "stepped up" capital gains tax basis.  The Obama proposal does away with the stepped up basis.  

     The Difference Between Estate Taxes and Capital Gains Taxes.  The estate tax rate on property that is not exempt from the estate tax is 40%.  That's a nasty bite to an inheritance.  Heirs indirectly pay the tax because it is money that the heirs never see -- the estate itself pays the tax on a 706 form, and usually pays it within nine months of the date of death and before distribution of what's left.  That's the bad news.  The good news, if there is any, is the government does not tax a certain level of estate tax proceeds.  Currently, the exemption is $5.43 million in 2015.  If the decedent's total property value is less than the exemption, or if the decedent is married, there is no estate tax at all when the first spouse dies.  With a concept called "portability," the second spouse to die can shelter nearly $11 million exemption from an estate tax.  Few American estates exceed $11 million. 

      The theory behind the "stepped up basis" doctrine was to mitigate somewhat the 40% tax.  The stepped up basis involves capital gains tax treatment, not estate taxes.  Earlier, the tax exemptions were lower and because estates paid an estate tax on some estate assets, the stepped up basis effectively held down capital gains taxation and was an important counter-balance to that 40% estate tax bite.  The current administration argues that with a large estate tax exemption in place, the rationale for the stepped up basis is no longer there. 

  • Grandma dies and gives grandson a quarter section worth $250,000.  Grandma paid $25,000 for it in 1957.  Had Grandma sold this land before her death for the same $250,000 her gain is $225,000.00.  She pays a hefty 15% or 20% tax.  However, at her death, the basis of $25,000 "steps up" to $250,000.  There is no capital gain tax on the inheritance.  The stepped up value of the land now goes to grandson.  If grandson later sells the ground for $275,000, the capital gain is the percentage -- 15 or 20% -- applied to $25,000 ($275,000 - $250,000).  If grandson pays the lowest rate, 15%, the tax is $3,750. 
Enter the Administration. 
  • In the administration's plan, grandson inherits Grandma's quarter section worth $250,000 today from her 1957 $25,000 basis.  It is treated the same way as if grandma sold the ground right before her death.  The "gain" is $225,000.00.  Grandson pays 15% of $225,000, not $25,000.  That's $33,750.  Unless grandson has a large line of credit at a bank, where does grandson get $33,750 to pay the tax without selling part of the farm?

     The 2016 Presidential election has perhaps changed everything.   The incoming President has not indicated any desire to change anything substantive about the Estate Tax or the Stepped Up Basis.  The 2017 Congress with be in unified Republican hands beginning January 20th.  Even Democrats may not like estate taxes or radical changes in these "out" years.  They may not go along with the President on this one, but it is doubtful that they have the locomotive power to get any changes of this nature passed. 

Smith, Burnett & Hagerman, LLC
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Larned KS 67550

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