This is part of a new CAP series called the “Tax Expenditure of the Week.” The series aims to explain the often-confusing constellation of tax breaks in a way the average taxpayer can understand. Every Wednesday we will focus on one tax expenditure, explaining what it is, what purpose it is intended to serve, and whether it is effective toward that purpose. We will also review relevant reform proposals.
Subjecting these dozens of tax breaks to greater scrutiny is part of our broader focus on making government work better and achieving better results for the American people, which is the goal of CAP’s “Doing What Works” project.
This week we’re looking at the special rule in the tax code that allows gains on property to go untaxed when they are bequeathed to heirs. This rule, called the “step-up in basis,” allows people to pass property that has grown in value to their heirs without ever paying taxes on the gains.
What is the “step-up in basis” rule?
In general, when you sell an asset that has risen in value, you pay taxes on the gain. For assets like stocks, the “capital gain” is generally calculated as the difference between the purchase and sale price.
For example, if you buy shares in a company for $100 and sell them for $300, you have $200 in capital gain. The original purchase price, $100, is called your “basis” in the shares.
But there is a special rule for inherited property. Here’s how it works: If you inherit a stock from your late aunt and later sell it, you are taxed on the difference between what you sold it for and what the stock was worth when Auntie died.
Let’s say Auntie bought the stock a long time ago for $1,000 and its value climbed to $50,000 during her lifetime. When you inherit the stock, your “basis” is the stock’s fair-market value upon Auntie’s death, or $50,000, rather than the $1,000 she paid for it.
That step-up in basis means that when you sell the stock now, you’ll only pay taxes on any gain above $50,000 that occurred while you held the stock.
Since Auntie held the stock until she passed away, she never “realized” the $49,000 in gain, and therefore never paid taxes on it either. So the step-up in basis rule means that $49,000 goes permanently untaxed.
We’ve used company stock as an example here but the step-up in basis occurs with other appreciated assets, such as real estate or closely held businesses, that are passed from one generation to the next.
The result is that hundreds of billions of dollars in income go entirely untaxed every year.
Why is it a “tax expenditure”?
Special provisions of the tax code that depart from the general rules and require the government to forfeit tax revenue it would otherwise collect are called “tax expenditures.” The step-up in basis at death is a tax expenditure because it shields capital gains from taxation.
How much does it cost?
The federal Treasury forfeits a substantial amount of revenue by not taxing the gain on assets held until death. In fact, according to the administration budget released this week, it is the fifth-largest tax expenditure.
Not surprisingly, this tax expenditure overwhelmingly benefits those who inherit from large estates because it allows gains to escape capital gains taxes if held until death.
While there are limited data on the income levels of the heirs who benefit from the step-up rule, it’s clear that the overwhelming majority of capital gains generally accrue to the highest-income earners. In fact, 62 percent of net long-term capital gains are enjoyed by millionaires; only 4 percent of capital gains accrue to households with income under $100,000.
Why let these gains go untaxed?
The step-up in basis rule solves some practical problems of taxing appreciated assets. For example, it may be difficult for heirs to determine the deceased person’s basis, especially for property that was acquired many decades earlier.
But the step-up rule is an ill-fitting and expensive solution. It applies equally to assets like publicly traded stocks where the original cost to the person who died can often be determined easily.
Another practical problem the rule resolves is that imposing a tax on capital gains at the time of the bequest could create problems for heirs who inherit an illiquid asset that cannot easily be converted to cash to pay the tax.
But this concern could be addressed by allowing the heirs a “carryover” basis in the property instead of a “stepped-up” basis. A carryover basis means the heir’s basis is the same as the decedent’s basis. Under a carryover basis regime, no tax would be paid when the property is transferred to the heir, but the heir would ultimately pay tax on the entire appreciation when he disposes of it. In fact, this is how gifts are treated.
The step-up in basis rule also has significant unintended consequences. It gives people a huge incentive to hold appreciated assets until death even if they would otherwise sell them. This dynamic is known as the “lock-in” effect and it distorts economic activity and investment.
The step-up in basis rule is one of the biggest tax breaks in the Internal Revenue Code. With a cost of more than $60 billion per year, it warrants at least as much scrutiny as direct government spending programs of that magnitude.
Seth Hanlon is Director of Fiscal Reform for CAP’s Doing What Works project. We hope you’ll find this series useful, and we encourage your feedback. Please write to Seth directly with any questions, comments, or suggestions. This series continues next week with a closer look at the preferential tax rates for capital gains.
. The step-up in basis rules temporarily expired for 2010, corresponding with the temporary lapse of the estate tax. However, legislation enacted in December gives the estates of people who died in 2010 the option of applying 2010 rules or 2011 rules. The 2011 rules reinstate the step-up in basis.
. New estimates in the president’s fiscal year 2012 budget show that the step-up rule has surpassed the combined tax expenditures for charitable giving, which we profiled last week, as the fifth largest. The largest four tax expenditures remain: 1) the health insurance exclusion; 2) the tax incentives for retirement savings, combined; 3) the mortgage interest deduction; and 4) the deductions for state and local income taxes and state and local property taxes, combined.
. One study, based on 1998 data, found that if capital gains were taxed when bequeathed, estates with assets of more than $1 million would pay 84 percent of the capital gains taxes. With an exemption of $500,000 in gain, 99 percent of the tax would be paid by estates with assets of more than $1 million, and more than 50 percent by estates with assets of more than $10 million. See: James M. Poterba and Scott Weisbenner, "The Distributional Burden of Taxing Estates and Unrealized Capital Gains at the Time of Death." Working Paper 7811 (NBER, 2000), table 10. Some of these assets are subject to estate taxes when transferred, and in this sense, the estate tax serves as a backstop to the income tax’s failure to tax unrealized gains. The higher the exemption level for the estate tax (the amount of assets that can be passed to heirs free of estate taxes), however, the more capital gains go untaxed. Congress recently raised the estate tax exemption level to $5 million for individuals and $10 million for couples. Under the new rules, only 1 in every 700 estates will be subject to the estate tax; the other 99.86 percent will be entirely exempt.
. Liquidity problems are further addressed by allowing the heir to pay taxes over multiple years.