Center for American Progress

3 Alternatives for Taxing the Capital Gains of the Very Wealthy

3 Alternatives for Taxing the Capital Gains of the Very Wealthy

Three distinct systems could replace the stepped-up basis loophole. They differ significantly, but each would increase taxes on the rich and dramatically improve on the status quo.

A predawn view of the U.S. Capitol on October 6, 2021 in Washington. (Getty/Drew Angerer)
A predawn view of the U.S. Capitol on October 6, 2021 in Washington. (Getty/Drew Angerer)

Under the current tax system, much of the income of the wealthiest people in the country is never subject to income tax. This results from the fact that capital gains—gain in the value of assets such as stocks—are not taxed until and unless the assets are sold. Due to the stepped-up basis provision, if a person holds onto assets without selling them and bequeaths them to heirs, the increase in the assets’ value is not subject to income tax. Journalist Robin Kaiser-Schatzlein has previously described this provision as a “supremely obscure and yet wildly consequential rule” that “might just be the most important tax loophole in America.” It creates large economic distortions and enables billionaires and other extremely wealthy people to effectively avoid a large amount of income tax for their entire lives. And even if the assets are sold and the capital gains are taxed, they are taxed at much lower rates than ordinary income.

This column first describes the existing system for taxing capital gains, then explains how three different proposals would reform it. All three alternative systems—constructive realization, carryover basis, and mark-to-market taxation (a targeted version of which is known as the Billionaires Income Tax)—would increase federal revenues in a highly progressive manner.

Under the current system, people can accumulate billions in wealth and avoid paying income taxes on their gains

Stepped-up basis is a loophole exempting certain capital gains from the federal income tax.

Wealthy investors are incentivized to hold assets until their deaths, even when switching to other investments might prove more productive.

Capital gains are the increase in value of an asset that a person holds. They are taxed when realized, that is, when the person sells the asset for more than they acquired it. For example, let’s say that the fictional Ian the Investor buys 100 shares of a company for $1 million and later sells those shares for $1.4 million. Ian will have gained $400,000 from these transactions and will therefore be taxed on $400,000 of capital gains income.

However, if Ian dies before selling his shares, the stepped-up basis loophole will exempt some of his gain from income tax. If the shares are valued at $1.3 million when Ian passes them to his heir, and if the heir later sells them for $1.4 million, Ian will pay nothing, and the heir will pay income taxes on a gain of only $100,000.* (The term “stepped-up basis” originates from the fact that the base price for the heir is “stepped up” from $1.0 to $1.3 million, the value on the date it was inherited.)

This loophole enables a large amount of tax avoidance. Wealthy investors are incentivized to hold assets until their deaths, even when switching to other investments might prove more productive. (For example, if someone at a 15 percent marginal tax rate were to invest $100 in an asset and see its value rise to $300, they could only reinvest $270 if they sold the asset. Therefore, even if the new asset pays a higher rate of return than the original asset, they might end up with less money because they had reinvested a lower amount.) Also, extremely wealthy people who hope to live off their fortunes can simply post their assets as collateral for loans. This tactic allows them to avoid income taxes on their unsold assets, even as those same assets finance extremely high standards of living.

Even when assets are sold, the capital gains income is subject to a lower tax rate than other forms of income. After accounting for payroll taxes, normal income taxes, and the net investment income tax, the top tax rate is 40.8 percent for ordinary income and just 23.8 percent for long-term capital gains. This lower, preferential rate results in part from the stepped-up basis loophole. The Joint Committee on Taxation estimates that, if policymakers were to raise capital gains rates above roughly 30 percent without changing the capital gains base, revenues would actually go down as owners of capital avoided taxes by holding more of their assets until death.


Average federal income tax rate for individuals in the Forbes 400 between 2010 and 2018

The present treatment of capital gains is the main reason the richest of the rich may pay lower tax rates than middle-class workers. A recent report from the Council of Economic Advisers and Office of Management and Budget found that, when counting capital gains on unsold assets, the Forbes 400 paid an average federal individual income tax rate of just 8.2 percent between 2010 and 2018. However, there are three possible alternatives to this system.

Alternative 1: Constructive realization

In his budget proposal to Congress, President Joe Biden proposed replacing stepped-up basis with “constructive realization.” Under that system, wealthy households would pay capital gains taxes when they gift or bequeath assets to their heirs. The gains would be realized for tax purposes as though a sale to a third party had occurred—hence the term constructive realization.

The Biden proposal is limited in two key ways that protect ordinary Americans and owners of family farms and businesses. First, under the president’s plan, couples can still use the stepped-up basis provision for up to $2 million of gains ($1 million per person). This means that, in effect, only a small number of families with substantial untaxed gains would be affected by the Biden proposal.

Second, the Biden plan allows those inheriting family-run farms and businesses to defer any tax on the original owner’s gains so long as the farms or businesses continue to be owned and operated by members of the family. (In practice, this means that gains on family-owned farms and businesses would be taxed under a system more akin to carryover basis than to constructive realization.) As tax expert Bob Lord and this piece’s author noted in a previous publication, these protections ensure that “no one inheriting and operating a family farm or business would be forced to sell it for the purpose of paying new taxes under the Biden plan.”

Alternative 2: Carryover basis

Policymakers have also considered an alternative to constructive realization known as carryover basis.

Under carryover basis, when an heir sells inherited assets that have appreciated in value, the decedent’s basis is “carried over” so that the heir pays income tax on the entire capital gain—not just the gain since they received the asset. In the example above, Ian the Investor would not pay any taxes on his pre-death capital gains, but his heir would pay taxes on $400,000—not merely on the last $100,000, as occurs with stepped-up basis.

Carryover basis and taxation at death would have different effects on federal tax revenues—especially in the short-term. Under carryover basis, wealthy families could still avoid capital gains taxes forever by holding onto inherited assets indefinitely. This avoidance strategy is not available under constructive realization.

Carryover basis would raise much less revenue in the traditional 10-year budget window, though it would raise more over time as inherited assets were eventually sold. For example, when the Congressional Budget Office (CBO) analyzed a policy option to implement carryover basis, it found that the policy’s revenues would rise seven-fold (as a share of GDP) over a 10-year time horizon.**

Alternative 3: Mark-to-market taxation, or the Billionaires Income Tax

The final alternative to stepped-up basis is mark-to-market (MTM) taxation. Lawmakers are considering a very targeted version of MTM taxation in the budget reconciliation bill. It would reportedly only apply to billionaires and those with annual incomes above $100 million.

MTM creates a different paradigm than the first two options. It would tax capital gains as they accrue, not at the point when assets are sold or transferred. For example, let’s say that Ian the Investor’s 100 shares rise in value from $1.0 to $1.09 million in year one; to $1.19 million in year two; to $1.30 million in year three; and to $1.40 million in year four, when the shares are passed to Ian’s heir. Under an MTM system, Ian would be taxed on $90,000 of capital gains income in year one, $100,000 of capital gains income in year two, and $110,000 of capital gains income in year three. Ian’s heir would then be taxed on $100,000 of gains in year four. In other words, MTM taxes capital gains in the year when they actually accrue rather than waiting and taxing them all at once when the assets are sold.

One MTM proposal currently being considered in Congress is Sen. Ron Wyden’s (D-OR) Billionaires Income Tax. Wyden’s plan would restrict the MTM regime to billionaires and those with nine-figure incomes, an approach that would still fix the biggest inequity in the tax code. The Billionaires Income Tax could be included in the budget reconciliation bill, but it has not been presented in detail, and there are a number of important design questions.

Under an MTM system, publicly traded assets are easily valued from year to year by looking at their going sales prices. But nonpublicly traded assets, such as works of art, are more challenging to value. A previous proposal from Sen. Wyden addressed this issue by continuing to tax capital gains on nontraded assets only when the assets are sold or transferred but then adding an interest charge at the time of sale. The interest charge would approximate the additional interest payments made by the government during the period in which investors were able to defer their taxes.

Sen. Wyden’s previous proposal also allowed taxpayers subject to the MTM system to claim a deduction for capital losses. In other words, they would have paid taxes if the value of their tradeable assets went up, but they also could have claimed a deduction if the value of those holdings went down.

Finally, if the Billionaires Income Tax is similar to Wyden’s original proposal, it will ensure that billionaires pay income tax on their enormous gains to date—not just the gains that will accrue after the MTM system is implemented. The tax payments on past gains could be spread over a number of years, though the exact number of years was not specified in the original plan.


Due to the existing system for taxing capital gains income, many rich Americans, including billionaires, are able to pay no taxes on a large portion of their lifetime incomes. Policymakers can eliminate this loophole in one of three ways—and each way would improve on the status quo. The worst system of capital gains taxation is the one we already have.

Nick Buffie is a policy analyst specializing in federal fiscal policy on the Economic Policy team at the Center for American Progress.

*Author’s note: However, those 100 shares will be assessed at their fair market value ($1.3 million) for purposes of the estate tax. For certain extremely rich families, the existence of the estate tax means that their unrealized capital gains will be subject to some taxation, even if those gains are exempt from the income tax. Still, any claims of double-taxation must be countenanced by the fact that virtually no one pays the estate tax, and those who do pay it have myriad planning techniques to minimize their tax bill. According to the most recent IRS data, just 0.19 percent of deaths triggered estate tax payments from 2011–2016; the Tax Policy Center claims that figure has dropped to 0.07 percent following the Trump tax cuts. As a result, very few families—and even very few of the richest families—will pay estate taxes on their unrealized capital gains.

**Author’s note: Author’s calculations based on the CBO’s December 2020 report on deficit reduction options and its February 2021 GDP projections. The author adjusted the CBO’s revenue estimate for fiscal year 2021 to reflect an implementation date of October 1, 2020 (the start of the fiscal year) rather than January 1, 2021.

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Nick Buffie

Former Policy Analyst, Tax and Budget Policy

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