What Is the 'Trust Fund Loophole'?

Few of us like paying taxes. That’s why high-income taxpayers in the U.S. are always looking for ways to reduce their tax bills. Under current law, estate planning offers opportunities to benefit the wealthiest Americans. One of those is called the “trust fund loophole.” This loophole in the U.S. tax code lets people use trusts to avoid the capital gains tax.

This article explains the tax consequences that happen when your heirs inherit assets that have appreciated in value. Trust and tax laws are complex. An experienced estate trusts attorney in your area can explain federal and state laws. They can also give you legal advice about your situation.

What Is the Trust Fund Loophole?

The capital gains tax is a federal tax. You pay it on your profit when you sell an appreciated asset. Common appreciating assets that are subject to capital gains taxes include real estate, stocks, and bonds.

For example, suppose you buy a stock for $100 and sell it for $150. You have a capital gain of $50. That’s also the amount you pay the tax on. Your capital gains rate depends on your income and filing status. It can be either 0%, 15%, or 20%. The middle class is typically in the 15% bracket. High-income people usually pay a capital gains tax rate of 20%.

The trust fund loophole refers to the “stepped-up basis rule” in U.S. tax law. The rule is a tax exemption that lets you use a trust to transfer appreciated assets to the trust’s beneficiaries without paying the capital gains tax.

Your “basis” in an asset is the price you paid for the asset. A “step-up” in basis is when the IRS lets you adjust the basis of the asset to its current value. In the above example, your basis in the stock is $100. If there’s a step-up in basis, your new basis is $150.

Because the capital gains tax rate is highest for high-income earners, it’s more common for the rich to use the loophole.

How Does the Trust Fund Loophole Work?

How does it all work? Remember, the trust fund loophole lets you transfer your appreciated assets to your heirs without paying capital gains tax on the increased asset amount. That’s because inherited assets get a step-up in basis.

Continuing with the previous example, suppose you put your $100 stock in a trust. The stock has gone up to $150 on your date of death. Following the trust’s terms, your daughter inherits the stock. If the stepped-up basis didn’t exist, your daughter would get the stock at your $100 basis. So if she later sells it for $250, she has a $150 capital gain ($250 sales price – $100 basis = $150 capital gain). Suppose her capital gain tax rate is 20%. She would have to pay $30 in capital gains tax ($150 capital gain x .20 capital gain tax rate = $30).

With the stepped-up basis rule, your daughter gets a basis step-up on the stock when she inherits it. So her basis is $150, not $100. If she later sells the stock at $250, her capital gain is $100 ($250 sales price – $150 basis = $100 capital gain). In this case, her capital gains tax would be $20 ($100 x .20 capital gain tax rate = $20). So with the loophole, your daughter’s tax liability goes from $30 to $20.

Is the Trust Fund Loophole Safe?

The trust fund loophole has been in place since the 1920s. The government estimates that people saved over $40 billion in taxes in 2020. U.S. presidents have tried to remove it over the years but have failed. But there’s a growing sentiment in the U.S. that the rich need to pay “their fair share,” which could mean a change in U.S. tax policy at some point.

Contact an Estate Planning Attorney for Help

Taking advantage of a tax loophole to leave your property to heirs tax-free is a common estate planning technique. When using trusts for tax purposes, things can become complex. The looming threat of tax reform makes the environment more uncertain. Contact an experienced estate trusts attorney for help. They can advise you about your options and ensure your trust follows state and federal laws.