It’s Worse Than It Looks

On Sunday, Paul Krugman highlighted  this chart from the Institute on Taxation and Economic Policy:

The chart illustrates that, when compared to their income, the wealthy do not bear a disproportionate share of the U.S. tax burden. (The web portal to the report is here and the full report can be downloaded here.)

I suspect that if one were to look at the calculation of income after factoring out several significant tax loopholes, one would discover that the calculation of the relative tax burden borne by the wealthy is actually significantly lower than the chart would indicate.

First, let’s look at the case of two individuals, Manny and Mo, who each purchase X shares of Acme, Inc. for 100K. Ten years later, the X shares are worth $250K. Manny sells his shares and has to pay tax on $150K. That’s because his tax basis is $100K and he has to pay tax on the gain, the difference between $250K and $100K.

Mo, on the other hand, dies on the same day as Manny sells his shares and her heirs sell the shares on that day. Because of the basis adjustment rules of IRC § 1014, Mo’s heirs pay no tax on the sale, because their basis in the stock is adjusted to its fair market value on the date of Mo’s death. The chart misses this “economic income” because, on their returns, Mo’s heirs don’t list as an exclusion ntheir true economic gain, the delta between $100K and $250K. Rather, they merely report a sale of property for $250K that has a basis of $250K. Thus, their economic gain is not reported in the income statistics. However, the Congressional Research Service has estimated that IRC § 1014 causes a serious revenue loss, $32.4 Billion in 2015 with that 92.7% of that loss benefiting taxpayers in top fifth of income.

But, as they say on TV, that’s not all. Wait until you crank IRC § 754 into the equation.

Assume that Larry, Moe, and Curly form a partnership and purchase an apartment complex for $1M. Ten years later, when the adjusted basis for each of them in the partnership is down to roughly $222K ($666K collectively), Moe dies. However, by that time the fair market value of his interest in the partnership is $700K (that is one-third of the total value of the apartment complex’s then FMV of $2.1M). If the partnership makes an election under IRC §754, Moe’s heirs begin to get tax losses based upon his $700K FMV. In other words, the depreciation from the increased FMV will likely generate losses that can shelter other income that Moe’s heirs have.

But There’s More!

Assume that at some point, Larry, Curly, and Moe’s heirs want to cash in and sell the apartment complex, thus shifting their asset base from an asset that they have to have to actively manage, to something like, say, an interest in a mixed use retail and office project that will be actively managed by a third party . Of course, they don’t want to pay taxes. So, they make use of the deferral provisions of IRC § 1031. IRC § 1031 allows the deferral of income recognition for tax purposes when the proceeds are invested in “like-kind” property.

And, of course, when Larry and Curly pass on, their heirs get a stepped-up basis in the new project and, like Moe’s heirs before them, get to shelter ordinary income. In other words, IRC § 1031 can be used not only to defer taxation on the sale of assets but, in many cases, avoid it altogether. (As an aside, there may be an additional level of tax avoidance if, for instance, the apartment complex is in, say, Maryland, which subjects income to taxation, but the mixed use project is in Florida which has no state income tax. Then, even if Larry and Curly are alive when their interest is sold, they will have avoided Maryland state income tax.)

The point is that in none of the above cases is the true economic income reported as taxable income. Stated more simply, for the wealthy the “blue bars” in above chart understate their actual income, thus reducing their relative tax burden.