UPDATED 12-11-2017
What is the tax rate when you are taxed on a loss?
We have a income tax system that purports to tax individuals on their income. But what if you made no money or lost money? Does that mean your income tax is zero? Yes. Usually. There are some instances where even though you have a loss, you will be taxed as if you had a gain.
Let's use a hypothetical
Max was born in Switzerland. When visiting the US, he met Eva, who was born in Brooklyn. She was a world class pianist and he was captivated with her. They married and moved to Europe to live together. In 2012, Eva's mother fell ill. Eva decided she should move back to the United States to help care for her. Max, for all intents and purposes, became a US person in 2012; first with a Visa and then as a resident alien in 2014.
A little background on Max: He was a big believer in gold. In 2001 he bought 10,000 ounces of gold (625 pounds!) at $270 an ounce and stored it in a bank vault in Zurich. His belief took some time to be validated, but as gold went over $1000 an ounce he felt rather proud of himself.
As gold peaked at over $1600 an ounce in 2012, he felt mighty proud of himself. He turned $2.7 million into $16 million in a little over 10 years (less some costs for gold storage). Max has seen the price decline since he became a US person to $1060, and so it's now only worth $10.6. Still, not too shabby, so in 2015 he decides to cash out to buy a rather nice home, pay for some educational expenses and get in better tax structures. He feels pretty good.
Until it was tax time. Because here's the question — what does Max owe the US government in income taxes in 2015?
The day he become a US person subject to the tax jurisdiction of the IRS was in in 2012 when gold was at $1600 an ounce. When he sold the gold he suffered a loss from that day when it sold for $1060 on ounce.
You may think Max has no tax due as since the day he became a US person, his gold just lost value. You may think he even has a loss he could apply to offset other gains he had. But you would be wrong. Completely wrong (well you would be logically and morally correct, so perhaps not completely wrong).
When calculating the capital gain, Max must use the basis of the gold when he first acquired the gold. The basis in the gold is the 2002 value, $2.7 million. It's not the $16 million the gold was worth when he became a US person. According to the IRS tax code, your basis in a gain is the value before you were even subject to the US tax code.
This results in a tax disaster: When Max sells his stash for $10.8 million, he doesn't realize a loss from the $16 million value, but rather, he has taxable capital gain of $8.1 million dollars of the $2.7 million. This means he is subject to the 20% long term capital gain rate 28% gold rate and the 3.8% ObamaCare/Medicare add-ons. His marginal federal rate is 31.8%. He is taxed at approximately $2.57 million dollars. Max owes $2.57 million dollars even though the entire time he was a US person, he did not meet any time of the criteria Glenshaw Glass test for income. He did not have a singular instance of an undeniable accessions to wealth.
He did not have a gain! Yet, he is taxed as if he did. So what is the effective federal tax rate when you are taxed on a loss?
I set-up the equation as such: -5,200,000x = 1,900,000. And using some Algebra I, solving for x we get -273% percent!
Wait. A negative tax rate? What the heck is a negative tax rate? A negative tax rate means you are taxed on losses. That is worse than the highest income tax rate imaginable!
If you are having difficulty understanding this absurdity, consider the inverse of this relationship. A negative income tax rate would mean the IRS gives you money when you earn money. The more money you make, the more money the IRS would give you. Now this does sound good; too bad it is not the law. Yet if the inverse does not work, how can the original transaction make sense?
It doesn't.
But how can this be? Someone's property is subject to the tax jurisdiction of the US, before the person is? This would mean that anything in the world is actually subject taxation by the IRS. If God became a US person and sold the Sun for $400 billion to the Chinese, well dang, I guess he'd have one heck of a gain to report.
I'm not arguing what the law is, what I am arguing is how we think of the law. If you suffer an income loss while you are a US person yet still owe a hefty income tax, that is what we call in the business, "really f*cked up".
I supposed my anger (yes, anger) at this stunningly barbaric rule is magnified as there is a simple fix — but only prospectively. The fix is to get good tax advice when someone becomes a US person.
Or I suppose tax reform would add a small little section that would give that new US person the basis on the day they became a US person. Yet, it seems we are a little late for that.
So instead, if Max was told by his attorney to sell his stock the second before he was a US person, and bought it back the second he became a US person, his basis would have been $16 million. And yes, he would have had a loss of $5.2 million he could have applied to other earnings. Ten seconds of advice could have saved millions of dollars. Now that's some value.
Now for those of you who find this fact pattern a bit convoluted I can assure I know of several instances where this has happened.
I am enjoying people being more interested in the tax laws that pretty much rule our life. But unfortunately, because tax law is so complicated, most commentators who do not live and breathe this stuff every day are going to miss out on the big stories, the true outrages.
Oh yeah — Passive Foreign Investment Company (PFIC) income — that's another story. But let's just say that a situation where you could be happy to pay a mere 100% tax on icome.
