President Obama as part of his expected State of the Union address will announce various tax related measures to help the lower and middle class and close certain "trust fund" loopholes. This loophole is primarily the ability to step-up assets to fair market value at death. Current law allows a step-up in value of almost all assets at death to fair market value.
For example, assume Farmer John owns 1,000 acres of ground that he purchased in 1960 for $100,000. That ground is now worth $10 million. When Farmer John passes away, his heirs will be able to sell the ground for $10 million and pay no income tax.
Under President Obama's proposal, Farmer John's heirs would still have an income tax basis of $100,000. In addition, President Obama wants to increase the top capital gains tax rate to 28%. Let's assume that Farmer John owes the 40% estate tax on all $10 million of value. In addition, let's assume that Farmer John lives in Washington state with a top estate rate of 19% which lops off another $1.9 million, however, this would reduce the federal estate tax liability by $760,000. We now have total estate taxes of about $5.14 million.
The heirs all live in California and elect to sell the farmland for $10 million. This results in about $2.8 million of federal tax plus about $1.3 million of California tax. Let's call it $4 million. the bottom line is $5.14 million of estate taxes and $4 million of income taxes. On $10 million, the heirs net about $900,000 or less than 10%. This is President Obama's definition of a "trust fund" loophole.
This is the worst-case scenario. It is likely that the heirs would be able to add the estate taxes paid to the income tax basis of the property (perhaps not the state estate tax) which would reduce the income tax liability by a bit more than a $1 million. But this would be a major change for many farmers.
This had been tried many years back and the administrative issues were immense. If the only person who knows the income tax basis of the asset has passed away, how easy is it to pin down the original tax basis of the property, etc. The chances of this passing with Republican control of the House and Senate is somewhere between slim and none, but it is always wise to know when you might be considered a "trust fund" loophole.