Say It Ain’t So, Joe. The Stepped-Up In Basis Tax Debacle

I usually don't wax politics in this blog, but I can't help myself when is comes to the current administration's proposal to cancel the Tax Code break called the "step-up in basis." I want to share my point of view on this matter because it sends chills down my spine.

NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

Ole Joe has had plenty of questionable moments in his half-century of “service” in Washington, D. C., and it’s hard to pick out the worst. But right up there with the best of the worst would be his proposed elimination of the century-old tax exemption for investment appreciation, which is triggered when an American passes on, whether affluent or not. It's the much cherished Tax Code break called the “stepped-up in basis.” Under current law, regardless of an investment's original cost, the basis of an investment “steps up” to current market for heirs of the deceased. In short, no taxes are due.

What's Changing?

The change proposed by the Biden administration involves the currently untaxed gains on investments – stock, bonds, land, business property, your home, etc. – held at death. Joe wants to tax those gains at the top rate of 39.6%. Of course, because he’s a generous man with your money, he’s talking about exempting $1 million of assets per individual plus $250,000 more for a home (for married couples, that would come to $2.5 million of gains).

And Joe’s generous management of your estate shines even brighter in that the higher tax rate wouldn’t be imposed on retirement accounts such as 401(k)s, 403(b)s, and IRAs. Well, maybe I’m giving him too much credit for generosity in those instances. Withdrawals and conversions to Roth accounts are considered ordinary income, not capital gains, which excludes them from the clutches of our newest D.C. investor advisor. But don’t hold your breath, he’s got very sticky fingers when it comes to taxation.

A Darn Big Deal

This elimination of stepped-up in basis is a really big deal. Based on calculations by the Congressional Joint Committee on Taxation, the stepped-up provision collectively saves heirs more than $40 billion a year.

The current federal tax rate on such investment gains is 0% (unless, under current law, an individual has a larger than$11.7 million estate at the time of death). Combined, those current two provisions eliminate most folks from having to pay federal estate taxes. Above the $11.7 million level, an estate tax of up to 40% might be imposed on the full asset value at death.

Forced to Sell

Another potentially negative impact of Joe’s proposal is that unless special exceptions accompany the change, an estate that owes this onerous tax might be forced to sell assets to meet the obligation. The sale of liquid assets is one thing. The sale of family farms or family-operated businesses is quite another. Deferments on inherited farms and/or businesses might…might…be available until the heirs no longer own or operate them. Or in the case of illiquid businesses, a timeframe over which to pay the tax bill might be granted, but right now, who knows.

Impact on Gifting

The impact on gifting is unclear. Currently, a gift of appreciated stock to a grandchild under today’s law doesn’t trigger a capital gains tax because the recipient takes over the deceased’s stepped-up cost-basis. Joe’s proposal doesn’t explicitly mention impacts on gifting. Thus, without a specific exemption, the proposal could very well trigger a capital gains tax on such gifts.

A Sad Example

Let’s do an example. I’m going to assume the role of a well-heeled property owner for a moment (just like in Monopoly) and that my sad and untimely demise has occurred. No doubt, it’s a melancholy time, but at the reading of the will, my executor has determined that I possessed assets of $4 million, including $3 million of stock accumulated over a period of many years…during good times and bad, including normal inflation (i.e., loss of spending power). After spending countless hours trying to determine my cost basis in the stock, my executor finally arrived at a “number” - $1 million. Under existing stepped-up law, my beneficiaries would owe no tax…zilch…nada. However, under Joe’s stepped-up elimination proposal, my final income tax return would show a net of $1 million of taxable gains at the proposed new rate of 39.6% plus Obama’s 3.8% surtax on higher earners’ investment income (note how these taxes stack on top of each other over time). The final tax bill? $1 million of taxable capital gains x [39.6% + 3.8%] = $434,000 in taxes as a result of this proposed new provision. This also depends on my other income in that sorrowful year. And it's not just sorrowful because of my untimely death - it's sad because my estate’s income tax will increase from $0 to at least $434,000, and the fact that most of the new tax my heirs must pay will be on assets whose value has been eroded over time by inflation.

Heavily Eroded Earnings

In short, Joe views capital gains as if they are current earnings, not the inflation-riddled appreciation of assets over long periods of time…that there has been absolutely no “purchasing power” lost to inflation over the years. We all know better than that, don’t we? Joe simply doesn’t seem to understand that long-term gains are, more often than not, heavily eroded by inflation…and because of this erosion, “patient investors” have historically been incentivized to finance, create, and build businesses with lower tax rates. In fact, not one of the globe’s 10 largest economies tax long-term capital gains at or close to ordinary income tax rates. Why? Competition. Capital seeks out its highest reward, and in today’s world, capital is very mobile. Our new president would argue that the loss of purchasing power has at the very least been offset by asset appreciation. Sure, Joe.

We Need to Act

Because of the magnitude of Joe’s stepped-up elimination proposal, this change in the tax code is not likely to come easy. Nor should it. But don’t sell him short. Soaking the rich has a certain appeal to lots of folks in this country. Even though the soaking always…always…trickles down. Case in point, the alternative minimum tax (AMT) was originally designed to tax about 200,000 wealthy taxpayers who, back in 1982, were “using” the tax system to pay little or no taxes. Due to inflation and cuts in ordinary tax rates, taxpayers owing AMT steadily rose to $5.2 million by 2017, most of whom were not rich. Thanks to a Republican Congress, the number was reduced back to $200,000 in 2018. Our new president is considering a reversal of that relief, too.

Joe, haven’t we suffered enough unrecoverable learning…enough physical and suicide-inducing despair…enough economic destruction…and enough social discord inflicted on us by COVID-19? Do we really need more of the same during the current recovery? Enough already!

If this outrages and scares you as much as it does me, I urge you to take action. How? Write your members of Congress and ask for their continuation of stepped-up basis. Heck, let's start a petition effort - it can't hurt, right?