Tax on Phantom Income

One of the widely accepted principles in the tax code is that you should be taxed on money you actually received. But there are a few examples of taxation on phantom income. The problem has the potential to get much bigger. On today’s show we’re talking about the concept of a deemed disposition. It’s pretty clear in the tax law of most western countries that if you sell an asset and you make a profit, that sale might be subject to capital gains tax.

But recently Janet Yellen, the new Treasury Secretary and former Fed Chair has been advocating that the government consider taxing unrealized capital gains.

The latest incarnation of this concept is called the “Sensible Taxation and Equity Promotion” Act of 2021, or STEP for short. Wonderful! Another catchy acronym for yet another destructive law.

Based on current US federal estate tax law, if someone dies today, his/her assets are exempt from federal estate tax up to $11.2 million, or $22.4 million for a couple.

That’s a hefty exemption that covers more than 99.9% of the population.

If it passes, the value of a newly deceased person’s estate will be valued at Fair Market Value.

Then, any unrealized capital gains would be taxed based on that person’s original cost basis.

Essentially they’re treating you as if, on the day that you died, sold all all of your assets and had to pay capital gains tax.

But they’ve dropped the exemption all the way down to $1 million.

Just about every asset is included, ranging from real estate to a small family business. They even specifically included collectibles like art, gold, and rare coins.

Some other countries like Canada don’t have inheritance taxes. But in Canada, there is a deemed disposition upon death and if any capital gains taxes are due, they need to be paid at that time when the terminal tax return is filed for the deceased person. The result has been that often the children will inherit a property that has been in the family for decades. The cost of the property was close to zero compared with today’s valuation. The new owners face a hefty tax obligation, or risk losing the property.

In many cases, the next of kin will need to get a bank loan to pay the taxes in order to hang onto the property. The only other choice is to sell the property and pay the tax on an actual disposition. In many cases, it’s preferable to transfer the property at a predetermined price while the parent is still alive in order to reduce the tax burden.

2021 could be the year of strategic tax planning.