Step Up In Basis: Law Change And Its Impact

Step-up in basis is a tax provision in the United States that adjusts the cost basis of an inherited asset to its fair market value on the date of the benefactor's death. This provision has been a part of US tax law since at least 1976, when the Tax Reform Act was passed. The step-up in basis provision allows beneficiaries to avoid paying taxes on capital gains accrued during the benefactor's lifetime. While this provision has been criticised as a tax loophole that primarily benefits wealthy households, attempts to change it have faced significant challenges due to complex design and implementation details.

The step-up in basis rule

Under this rule, when a person (the beneficiary) receives an asset from a benefactor (the giver) after the benefactor dies, the asset receives a stepped-up basis, which is its market value at the time the benefactor dies. This can be higher than the before-death cost basis, which is the purchase price of the asset, adjusted for improvements or losses.

A stepped-up basis can greatly reduce the beneficiary's taxable capital-gain income if they sell the inherited asset. This is because taxable capital-gain income is the selling price minus the basis.

For example, if a benefactor owned a home that they purchased for $35,000, then their basis in the home would be $35,000, assuming no adjustments for improvements or losses. If the fair market value of the home was $100,000 when the benefactor died, then after the beneficiary inherits the home, their basis in the home becomes $100,000. So, if the beneficiary were to sell the home for $100,000, they would not have to pay any income tax because the sales price minus their stepped-up basis would result in a capital-gain income of zero.

The primary purpose of the stepped-up basis rule is to ensure that, for estates without exemptions to the federal government's estate tax on transfers of wealth at death, the estate's assets are taxed only by estate taxes and not also on the capital gains during the decedent's lifetime. Additionally, the step-up basis rule avoids the difficulty of ascertaining a decedent's adjusted basis in property that could have been held for decades.

Opponents of the stepped-up basis rule argue that it is a tax sheltering strategy that primarily benefits wealthy taxpayers and that it represents an unfair loophole in the tax system, as it shields some capital gains from ever being taxed. They also argue that it creates an incentive and a pathway to continue passing assets from one generation to the next within the same family, thereby contributing to the concentration of wealth.

However, others argue that eliminating the stepped-up basis rule would result in a form of double taxation, as it would combine the estate tax and the capital gains tax. They also argue that very few estates face taxation due to the high threshold for the estate tax.

There have been previous attempts to change the step-up in basis rule. The Tax Reform Act of 1976 imposed a carryover basis for inherited assets, meaning that taxpayers inheriting assets with a capital gain would also inherit the asset's original basis. This change was retroactively repealed and replaced by 1980. There was also an attempt to introduce a carryover basis in the Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001, but this was also ultimately repealed.

Most recently, the Biden Administration has proposed eliminating the step-up in basis rule as part of its American Families Plan. This proposal could make the tax system more progressive, align the taxation of income from investments with that of wage earnings, and raise significant revenues. However, it would also have a significant effect on how Americans plan their estates and pass assets on to their heirs.

Capital gains tax

Step-up in basis is a provision in the US tax code that adjusts the cost basis of an inherited asset to its fair market value on the date of the benefactor's death. This provision significantly reduces the capital gains tax liability for the beneficiary if they decide to sell the asset. The capital gains tax is calculated as the selling price minus the basis, so a high stepped-up basis can considerably lower the taxable capital-gain income.

Under the current law, taxpayers pay taxes on capital gains when they sell an asset for a profit. However, taxpayers can also hold onto assets with unrealized capital gains and pass them on to an inheritor at death. In this case, the asset's tax basis is stepped up to its fair market value, and the inheritor does not owe capital gains tax on past increases in value. This provision incentivises taxpayers to retain appreciated assets until death and sell assets that have decreased in value during their lifetime.

The step-up in basis provision has been criticised as a tax loophole that primarily benefits wealthy households, as it allows them to pass on substantial assets without incurring capital gains taxes. In 2020, the Congressional Budget Office (CBO) estimated that over half of the aggregate benefit goes to the top 5% of taxpayers by income, with a cost to the government in foregone tax revenues of $110 billion over 10 years.

There have been several attempts to change the step-up in basis provision. In 2021, President Biden proposed eliminating the step-up for assets exceeding $2.5 million for a married couple, but this failed to secure congressional approval. The Tax Reform Act of 1976 imposed a carryover basis for inherited assets, meaning that taxpayers inheriting assets with a capital gain would also inherit the asset's original basis. However, this change was retroactively repealed by 1980 due to implementation complexities and concerns about liquidity and exemptions. Similar attempts were made in 2001 and 2010, but these also failed to result in lasting changes to the step-up in basis provision.

The Biden administration's proposed changes

The Biden administration has proposed changes to the "step-up in basis" rule as part of its Build Back Better agenda. This proposal, known as the American Families Plan, aims to make the tax code more progressive and less advantageous for the wealthy.

Firstly, the Biden administration has proposed raising the top capital gains tax rate to 39.6% from the current rate of 20%. This change would significantly impact inherited and highly appreciated assets, resulting in a higher tax burden on capital gains for taxpayers with $1 million or more in annual income.

Secondly, the step-up in basis provision would be adjusted. Under the current law, when a person inherits an asset after the owner's death, the asset's basis is "stepped up" to its fair market value, and the inheritor does not owe capital gains tax on past increases in value. The Biden administration's proposal would cap this benefit to $1 million of the gain for a single person or $2 million for a married couple. Any unrealized gains above this exemption amount would be taxable.

For example, consider a farmer who purchased 200 acres of farmland in 1990 for $400,000. Today, those 200 acres are worth $2,400,000. If the farmer holds ownership until death, under the current law, the original cost basis would receive a "step up," and a new cost basis would be established based on the date of death value. If the farmland is then sold by the farmer's beneficiaries for $2,400,000, there would be no capital gain realized and thus no tax owed. However, under the Biden proposal, only $1 million of the $2 million gain would receive the step-up, and the remaining $1 million would be taxable.

The impact on estate planning

The step-up in basis is a provision in the US tax code that adjusts the cost basis of an inherited asset to its fair market value on the date of the benefactor's death. This provision significantly impacts estate planning, as it can reduce the capital gains tax owed by the heir when they sell the inherited asset.

Under the step-up in basis provision, the beneficiary's basis equals the fair market value of the asset at the time of the benefactor's death. This can result in a stepped-up basis or a stepped-down basis. A stepped-up basis occurs when the market value of the inherited asset is higher than its original purchase price at the time of the benefactor's death, while a stepped-down basis occurs when the market value of the asset has decreased. In practice, most inherited assets after death are stepped up, as financial assets passed on to heirs are often long-term holdings, and financial assets and real estate tend to have favourable long-term rates of return.

The impact of the step-up in basis provision on estate planning is significant. It allows heirs to sell inherited assets with minimal or no income tax incurred. The cost basis is stepped up to its fair market value, reducing the capital gains tax liability of the heir. This provision effectively eliminates the capital gain that occurred between the original purchase and the heir's acquisition, and this gain is never taxed. As a result, the step-up in basis provision can be a powerful tool for estate planning, particularly for high-net-worth individuals.

However, critics argue that the step-up in basis provision primarily benefits wealthy households and leads to a loss of public revenue. According to the Congressional Budget Office (CBO), over half of the aggregate benefit accrues to the top 5% of taxpayers by income. In response to these concerns, there have been several attempts to limit or eliminate the provision, including a proposal by President Biden in 2021 to eliminate the step-up for assets exceeding $2.5 million for a married couple. However, this proposal failed to secure congressional approval, and the step-up in basis provision remains in place.

The step-up in basis as a tax loophole

The step-up in basis is a provision in the US tax code that adjusts the value or "cost basis" of an inherited asset to its fair market value on the date of the benefactor's death. This provision effectively reduces the capital gains tax owed by the recipient when they sell the asset. For example, if a benefactor purchased a home for $35,000 and made no adjustments, their basis in the home would be $35,000. If the fair market value of the home at the time of their death was $100,000, the beneficiary's basis in the home would be stepped up to $100,000. If the beneficiary were to sell the home for $100,000, they would not owe any capital gains tax as the sales price minus the stepped-up basis would result in a capital gain of zero.

The step-up in basis provision has been criticised as a tax loophole that primarily benefits wealthy households. According to the Congressional Budget Office (CBO), over half of the aggregate benefit accrues to the top 5% of taxpayers by income. In 2020, the CBO estimated the cost of this provision in terms of foregone tax revenues at $110 billion over 10 years. This criticism has led to efforts to limit or eliminate the step-up in basis provision in recent years, although these attempts have been unsuccessful.

The step-up in basis provision provides an incentive for taxpayers to retain appreciated property until death, as any appreciation of the property during their lifetime will never be taxed. This can result in generational wealth transfer without the application of tax on built-in gains. Additionally, the step-up in basis discourages the realisation of capital gains and reduces compliance costs for heirs, as tracking the cost basis of long-held assets can be difficult.

Despite the criticism and attempts to change the step-up in basis provision, it continues to be a legally established part of the US tax code. Supporters of the provision argue that eliminating it could disincentivise saving and result in double taxation when combined with the federal estate tax. Furthermore, the step-up in basis helps to mitigate the effective tax rate on saving by preventing taxpayers from paying both estate and capital gains taxes on the same inherited asset.

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