One of President Biden’s most impactful, but least discussed, tax proposals is the repeal of the so-called “step-up in basis” upon inheritance of a decedent’s estate. But as a group of Republican senators argued in a recent letterto the President, it’s a change that stands to do a great deal of harm to businesses and agricultural operations should it be passed.
The step-up in basis essentially “resets” the cost basis of an asset upon inheritance for the purpose of capital gains taxes. This protects heirs from paying a hefty tax should they decide to sell inherited assets.
Take a highly simplified example where a decedent purchases an asset for $1 in 1970. Upon that person’s death in 2020, the asset has grown to be worth $10. Absent the step-up in basis, the heir would be responsible for paying taxes on that $9 capital gain should they choose to sell the asset. The step-up in basis allows the cost basis of the asset to be reset to its value when the heir acquired it (in this case, $10). Should the heir decide to sell the asset before it appreciates further, they would not owe any capital gains tax.
Now, this is certainly not a perfect tax policy, and it can create opportunities for tax avoidance. But the step-up in basis does not exist in a vacuum, and eliminating it would compound other flaws in the tax code.
One problem is the existence of the death tax. The death tax often forces heirs to sell off certain inherited assets, such as stocks, real estate, or even stakes in a family business, just to pay the tax bill they receive for inheriting deceased family members’ assets.
In the absence of the step-up in basis, the burden of the death tax would only grow. Heirs could still have to sell inherited assets to pay their death tax bill, but they would then have to pay capital gains taxes on the assets they sold to pay the estate tax. The death tax is unfair enough as it is without this one-two punch.
Another problem is inflation. Much of the supposed gains subject to capital gains taxes, particularly those passed down from one generation to the next, are driven by inflation rather than appreciation of the underlying asset. Take the above example — though the heir has a capital gain of $9, $6 of it is due solely to inflation. The step-up in basis is a tool, if a somewhat unwieldy one, to shield heirs from paying taxes on inflation.
The final problem is a simple administrative one. Decedents do not always keep adequate paper trails for assets that could have been acquired decades ago, meaning that establishing the original cost basis can be near impossible at times. The step-up in basis facilitates estimations of cost basis by resetting it each time an asset is inherited — meaning that a failure to maintain adequate records of cost basis when an asset is acquired can only be the fault of the heir, not a deceased relative.
Furthermore, the step-up in basis has positive economic effects, the elimination of which is not worth the $11-12 billion a year in additional revenueto be gained from step-up in basis repeal. Namely, the step-up in basis discourages heirs from realizing capital gains from inherited assets. As a result, the step-up in basis effectively encourages saving, a beneficial economic activity.
So while the step-up in basis may represent imperfect tax policy, any serious effort to replace it necessitates grappling with the above issues. So long as President Biden wishes to repeal the step-up in basis as a standalone policy, any proposal to do so should remain a non-starter.