The Tax Loophole (Almost) Everyone Should Want to Close
Step-up in basis for capital gains explained
In his latest round of tax proposals, President Obama finally called for what is probably the single most obvious change that should be made to the tax code: an end to the step-up in basis at death for capital gains taxes. (The other candidate for “single most obvious change” is eliminating the “carried interest” exemption that allows fund managers to pay capital gains tax rates on their labor income — managing people’s money.)
What is step-up in basis, you may ask? Ordinarily, if you buy something for $100 and sell it for $200 — say, a share of stock — your $100 in profit is a capital gain, which counts as a form of income, and you pay tax on it. The capital gain is calculated as your sale price of $200 minus your “cost basis” of $100. You pay tax at a lower rate than on ordinary “earned” income, like your wages, for reasons that not everyone agrees on. In addition, you also benefit from the fact that you can decide when to sell the stock, so you can defer paying capital gains tax for as long as you want, without interest — so the longer your holding period, the lower the effective annual tax rate.
But wait, there’s more. Let’s say that, moments before hitting the “sell” button on your computer, you keel over dead from a heart attack. Your daughter inherits the share of stock and sells it the next day for $200. Instead of paying tax on a $100 capital gain, however, she pays no tax at all. The trick is that when the stock transfers from you to your daughter, its basis “steps up” from the $100 you paid to the $200 it is worth when you died; if she sells it immediately, she has no income at all. So who pays tax on that $100 in profit that your family made? No one.
Why this provision exists is not entirely clear. There are two leading explanations. One is that your daughter might have trouble figuring out what you paid for the stock decades before, and so this is a matter of administrative convenience. To the extent that used to be true, it clearly doesn’t apply today, at least not to the vast majority of assets that people buy and sell.
The second explanation is that this tax break benefits people who actually have assets to leave to their children — that is, the rich. We’re not talking about a couple hundred thousand dollars in mutual funds, which will only have modest unrealized capital gains, or a house, which already has its own special capital gains exemption. We’re talking about assets that have grown in value for decades, like large stakes in the family corporation. In other words, the tax break exists because rich people want it. Well, that’s still true.
You might think that the tax on the $100 is taken care of by the estate tax, which does have a hefty rate of 40%. This is sort of true. But it’s important to remember that the estate tax has a hefty exemption — close to $11 million for a married couple. So plenty of appreciated assets are getting passed down to the next generation free of both capital gains and estate tax. In addition, the estate tax is supposed to be more than just an indirect way of collecting capital gains taxes.
Simon Johnson and I proposed eliminating this tax break in White House Burning, and it’s always seemed to me like an obvious one. There are vaguely plausible arguments for lower taxes on capital gains. There are even arguments for allowing people to defer those lower capital gains taxes indefinitely. But the arguments for simply eliminating capital gains taxes for people who inherit wealth from their parents are completely implausible. Basically they come down to “all taxes are bad, so all tax breaks are good” or “increasing taxes on the rich is class warfare.” Even if you believe that lower capital gains taxes encourage saving, which is good for the economy (a proposition for which the empirical evidence is decidedly disappointing), it doesn’t follow that you should eliminate capital gains taxes altogether — but only for people who are rich enough to avoid selling assets before they die. Similarly, even if you believe we should have a consumption tax and no taxes on investment income at all, it doesn’t follow that that should be the case only for the wealthy.
In short, the step-up of basis at death is a tax loophole that rewards one thing: dying with lots of assets that you never needed to sell. How could this loophole possibly survive in a democratic, supposedly meritocratic society? Well, we’re about to find out — because it’s going to survive at least until the Democrats have sixty votes in the Senate, which may be never.
James Kwak is, among other things, an associate professor at the University of Connecticut School of Law. Find more at Twitter, Medium, The Baseline Scenario,The Atlantic, or jameskwak.net. This article is yet another in a series of futile attempts to raise his own taxes.
