Stop giving away capital gains taxes

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There is a rule that has been part of the tax code for nearly a century that safeguards the wealth of the rich, but violates nearly every principle of sound tax policy. Yet it persists, costing our national coffers $40 billion or so each year. Even by federal government standards, this is a significant dollar figure today. Indeed, stumping on the campaign trail, presidential candidate Joe Biden proclaimed that closing this loophole could pay the tuition for all qualified applicants to attend community college for free.

This arcane rule is colloquially known as the “step up in basis” rule. It dictates that, to compute gains and losses, a taxpayer who sells an asset that he or she inherited must use the fair market value of the asset at the date of the death of the individual bestowing it, rather than the original purchase price, also known as cost basis, which is typically much lower.

By way of example, consider the situation of Jeff Bezos. Assume that he originally invested $100,000 to form Amazon and that the fair market value of his stock is now $100 billion. His tax basis would be $100,000, and if he sold his stock, he would be taxed on every dollar he received in excess of that amount. But if Bezos passed away tomorrow, the “step up in basis” rule would erase his entire accumulated gain from income taxation. His heirs would inherit the Amazon stock with a $100 billion tax basis, and could sell the stock tax free, depriving the Treasury of nearly $25 billion.

Bezos and his heirs are not alone. Application of this rule primarily inures to the benefit of the 1 percent and uber wealthy who own the bulk of appreciated assets. Few other tax rules hermetically seal wealth from income tax today, tomorrow, and forever. The origins of this rule are murky. The most probable reason for its institution back 1921 is heirs often did not know the original price of assets that their benefactors left to them, which had made accurate tax basis identifications rather difficult.

But that was then. Now, in most situations, tax basis identification is a cinch. The tax code requires proper tax basis identification of marketable securities, which comprise a significant share of inherited wealth, held by third party brokers like Morgan Stanley or Merrill Lynch. Many business assets need accurate depreciation and amortization records that facilitate tax basis tracing. Finally, real estate assets are subject to public recording systems that make ascertaining their original cost more simple to locate.

Reforming the status quo would therefore be relatively easy. Congress could mandate that upon death, instead of the “step up in basis” rule, a carryover tax basis rule would apply. In the case of the death of Bezos, his heirs would receive a $100,000 tax basis with the stock they inherited. Narrow exceptions for collectibles and other asset categories could be made if Congress deemed that desirable. Even with a few exceptions, Congress could still capture most of the revenue it currently forfeits.

So why have politicians not tried to pick this low hanging revenue fruit? It is largely because, almost half a century ago, Congress tried instituting a carryover tax basis rule, but eventually repealed it, due to an outcry from lobbyists insisting that accurate basis identification was an exercise in futility. However, tax basis information is readily available in the digital era. At a time when the nation hungers for infrastructure improvements, the federal budget deficit skyrockets, and payroll tax rates hurt the working class, the repeal of such anachronistic tax rules makes imminent sense.

The “step up in basis” rule in the tax code meets the criterion that it is a wholesale subsidy to the wealthy that has lasted much longer than the administrative rationale that had propelled and underpinned its existence. The only question is whether politicians will demonstrate the necessary leadership skills and courage to educate the public that the United States is in dire need of a tax code that will conform to the pressing economic needs of today, not one mired in all the obsolete concerns of yesterday.

Jay Soled is a business professor and director of the masters program in taxation at Rutgers University. He is senior counsel to Wuersch & Gering.

Tags Business Congress Finance Government Money Policy Taxation Washington

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