These Tax Loopholes Probably Aren't Helping You Much

February 18th 2017

The 2016 presidential election featured a lot of talk about our tax system—and especially about making the rich pay their fair share.

But how do the rich actually manage to take advantage of our tax system? These three loopholes are among the three most glaring ways that wealthy Americans manage to minimize their tax burden.

1. Capital Gains

A 2011 report by the Congressional Research Service found that income from capital gains were the single largest driver of wealth inequality between 1996 and 2006.

Capital gains are income made off investments—stocks, funds, bonds, and the like. Capital gains are taxed at a lower rate than other forms of income—usually around 15 to 20 percent, depending on your income bracket, on assets held over one year. For people making below $37,650 per year, their capital gains are not taxed at all. On its surface, this low rate makes a lot of sense. In order to incentivize people to invest their money back into the market—providing our businesses with much-needed capital—the government keeps the tax rate on earnings made from investments quite low, sweetening the deal for would-be investors.

IRS Building Washington DCTim Evanson -

But this rule allows the ultra-rich to proportionatley pay a far lower rate than most Americans, because for many very wealthy individuals, a greater share of their income comes from investments than from actual salary.

It's the capital gains tax rate that allows Warren Buffet to safely say that he pays a lower rate than his secretary. It's the rule that allowed Republican presidential nominee Mitt Romney to infamously pay 15 percent in taxes. This 2012 article from The Christian Science Monitor explains the process in more detail, but because Romney and Buffett are essentially professional investors, their income is mostly profit from investments—even though they don't put much of their own money at risk.

Mitt Romney and Dan QuayleGage Skidmore -

And that zero percent rate on investors making lower than 37,650? It's a farce mostly. Most Americans making that little in salary aren't big investors—after providing for their basic needs, they have very little money left over to put into the market, if any. And 100 percent of zero is still zero.

2.The Stepped-Up Basis Loophole

Often, the ultra-rich avoid even paying capital gains taxes at all, using something called the stepped-up basis loophole. Often called the "trust fund loophole," the stepped-up basis loophole allows very wealthy individuals to pass their assets to their heirs without paying taxes on their capital gains.

Here's how it works:

Normally, when someone cashes out on an investment—sells a stock, for example—one pays the capital gains tax on their profit. So if you bought $50 worth of stock and sold that same stock a few years later for $500, you'd pay a capital gains tax on the $450. But what if you never sold? What if you died with assets still in stocks, not in cash. Well, you could pass those shares on to your heirs. Except the stepped-up basis loophole allows your heir to inherit the new value of the stock—the $500—as if it were the original value. It basically resets the counter on what counts as profit. As such, you would have $500 worth of stocks tax-free.

Wall Street Charging BullSam Valadi -

As Josh Hoxie writes at the Institute for Policy Studies. "Suppose you buy stock worth $100,000 (the 'basis' value in tax terms) that appreciates to $1,000,000 over the time you own it. When you die, your heir inherits the stock valued at $1,000,000. Under current law, neither you nor your heir would ever pay any tax on that $900,000 appreciation. Your heir’s inheritance instead gets 'stepped up' to $1,000,000 and, thanks to this 'stepped-up basis,' the heir does not owe capital gains tax either at the point of transfer or when the asset is sold."

In the 2012, the Office of Manage and Budget estimated this loophole would cost the government coffers $400 billion over the next five years.

3. Mortgage-Interest Deduction

Family with For Sale SignMark Moz -

This policy was originally designed to give a break to homeowners, and to encourage Americans to buy homes. However, even though the deduction does benefit homeowners, it helps homeowners with bigger mortgages even more, as Ben Casselman points out in FiveThirtyEight. He writes, "In 2013, 73 percent of that $70 billion [tax break] went to the wealthiest 20 percent of earners; 15 percent went to the richest 1 percent. The poorest 20 percent, who rarely own homes, got essentially nothing."

The mortgage-interest deduction amounts to what is essentially a government subsidy for home ownership. But according to Emily Badger and Christopher Ingraham in the Washington Post, the deduction applies to secondary homes, too, benefiting the rich even more, as they are far more likely to have vacation homes. The deduction even applies to mortgages on yachts, as long as the yacht is big enough to be considered a secondary home.

Large Yacht entering HarborMoshi Anahory -

The Center for Budget and Policy Priorities estimates the this deduction costs the government about $70 billion per-year, "but it appears to do little to achieve the goal of expanding homeownership."

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