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A Project of The Annenberg Public Policy Center

Obama’s Loophole Logic

The White House is claiming that the top 1 percent of all earners would pay 99 percent of the capital gains tax increase proposed by the president. But that claim rests on some debatable logic.

According to the Obama administration’s way of figuring, a lot of Americans would suddenly enter the top 1 percent only after they die.

An independent analysis by the Urban-Brookings Tax Policy Center estimates that the top 1 percent of earners would bear 58 percent of the increase, not 99 percent. By the TPC’s figuring, the Obama proposal would affect not only the rich, but a good many middle-income taxpayers as well.

Which view is right? That depends on what one considers to be “income,” as we shall explain in a moment.

‘Trust Fund Loophole’

The administration is proposing to end what it calls the “trust fund loophole,” which actually has little to do with trust funds. A more descriptive name for it would be the “Angel of Death” loophole, a term coined by journalist Michael Kinsley. Tax wonks know it as the “stepped-up basis” feature of the tax code, which Obama proposes to end.

TPC Director Len Burman explains it this way: “If grandpa leaves you shares of stock that he bought for $10 and are now worth $100, you never have to pay tax on the $90 of appreciation. Under the [Obama] proposal, grandpa’s estate will be taxed on the $90 profit on his final tax return.” 

Every year, U.S. Treasury officials estimate, something like $200 billion in unrealized profits escape capital gains taxation in this way. That’s because federal income tax has never applied to capital gains (profits on the sale of assets such as stock or real estate) until the asset is sold and the profits are realized. So anyone who holds onto an appreciated asset until he or she dies never pays any capital gains tax on the paper profit.

But — and here’s the loophole — heirs who inherit the asset never have to pay income tax on that profit either. That’s because the law allows them to figure their own taxable “basis” of the asset at the value at the time it passed to them, and not at what “grandpa” actually paid for it. Obama would force grandpa’s estate (or grandma’s) to pay capital gains taxes on those unrealized gains after he or she dies.

To be sure, some of the untaxed gain may later be subject to estate taxes, which fall on the total value of an estate. That total value includes the unrealized gain in any asset. But estate taxes currently fall only on the total value of estates worth more than $5.4 million (or effectively $10.8 million for couples). The fact remains, under current law, a person at any income level may avoid paying capital gains tax by holding onto assets until death, and heirs will also escape the capital gains tax on “grandpa’s” unrealized profit.

Is Grandpa a 1-Percenter?

But are grandpa and grandma in the top 1 percent of all earners? Not as often as the White House would like you to think, according to the TPC.

According to the administration, “the proposal is highly progressive, with 99 percent of the tax increase coming from the 0.8 percent of taxpayers with income over $500,000.”

But TPC sees it differently. It points to Federal Reserve Board figures on household wealth that it says show lots of middle-income households hold unrealized capital gains. Even after allowing for the exclusions that Obama proposes — (he wouldn’t tax the first $100,000 of unrealized gains for singles, or the first $200,000 for couples, for example, and gains on primary homes would keep their current exemptions) — the TPC figures that the top 1 percent would bear 58 percent of the proposed capital gains tax increase, not 99 percent. Those in the middle one-fifth of all households would bear 6.5 percent of the increase, TPC figures.

The difference comes about because the administration counts the newly taxed but unrealized gains as “income,” even though those profits weren’t pocketed during the decedent’s lifetime. Treasury gives a hypothetical example of “an individual who has accumulated a $10 million gain on shares of corporate stock but who was living off of $100,000 per year in other retirement income.” This person was well below the top 1 percent in the years before death, but by Treasury’s accounting, he or she suddenly has an “income” of $10 million after death, and becomes one of the top 1 percent.

Treasury says it would be “misleading” not to count the unrealized gain as income in the year the person dies. The TPC disagrees. It excludes those unrealized gains — which may have accumulated over many years — when it counts a household’s cash income in the year the taxpayer dies.

The Obama administration has attacked TPC on this score. On National Public Radio’s “Morning Edition” on Feb. 2, the director of the Office of Management and Budget, Shaun Donovan, accused the TPC of “fundamental flaws” in its analysis. “[T]hey actually assume that all of this income from capital gains isn’t really income,” he said. “It sort of defies logic to say that a family that had $500,000 of capital gains, that isn’t income.”

Burman then responded in a Feb. 2 post on the TPC’s website. “It is certainly true that taxable income on a decedent’s tax return would increase under the President’s proposal, but our measure of income, called expanded cash income, is intended to track pre-tax economic status. That doesn’t change just because a tax is levied on accrued gains.”

Our Conclusion

The president made this remark Feb. 2 when discussing the budget: “Right now, our tax code is full of loopholes for special interests — like the trust fund loophole that allows the wealthiest Americans to avoid paying taxes on their unearned income.”

But some middle-income Americans may be surprised to find they would be among the “wealthiest” who could pay more.

Our judgment is that it’s the administration, not the Tax Policy Center, that’s being misleading. We agree that it’s fair to count unrealized capital gains as “income,” but it’s not fair to count these paper profits that built up over many years as income in a single year. The administration’s definition also guarantees that no household with under $100,000 in “income” will be affected, because it counts any unrealized gain as income and then excludes the first $100,000 from taxation.

— Brooks Jackson

Update, Feb. 6: Treasury spokeswoman Erin Donar told us that “more than half” the difference between the two estimates is due to Treasury’s use of detailed tax-return data that isn’t public, and not simply to Treasury’s way of counting unrealized gains as income at death.

Her full quote: “[M]ore than half of the difference between the TPC and Treasury estimates of the share of the proposal affecting the top 1 percent is due to Treasury’s more robust data sets — including data from 2010 that cover unrealized gains — as well as Treasury’s more rigorous treatment of that data. TPC is only able to rely on the [Federal Reserve’s] Survey of Consumer Finances which understates wealth at the very top.”

TPC itself has conceded that it “would likely estimate a different distribution of tax burdens if we had access to those data” that are available to Treasury. These data include unique information from Form 8939, filed by only a few thousand estates of people who died in 2010. In that year, the estate tax was repealed, but heirs did not receive any stepped-up basis. So the IRS required reporting of decedent’s basis. The estate tax was reinstituted in 2011, so that is the only year for which that information was required.

Also, we agree that there’s evidence that the Federal Reserve figures used by TPC understate wealth at the very top, at least to some degree. A study of Form 8939 data by Treasury’s own Office of Tax Analysis stated that “high net worth decedents had a slightly larger share of their estate in untaxed capital gains than is indicated” by Federal Reserve data. 

But if “more than half” the difference between TPC and Treasury is due to factors other than the way each defines income, there is still a lot of room between 99 percent and 58 percent, and more of the burden would fall on those further down the income scale than the administration would like taxpayers to believe.