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The House is expected to vote today to reduce, then repeal the estate tax. The tax currently applies to only about 5,000 of the nation’s largest estates —those worth more than $5.49 million per person (nearly $11 million for a couple). The House version of the Tax Cuts and Jobs Act (TCJA) not only would repeal the tax on those estates, it also would allow a large share of their income to escape any taxation at all. This creates a giant inefficient and inequitable loophole for the very wealthy. If the estate tax is to be repealed, it would make sense to follow practice in past proposals by taxing capital gains on assets held at death.
With a few exceptions, capital gains are taxed when an investor sells capital assets. Capital gains are the value of an asset when it is sold or exchanged minus its “basis”, which is the original purchase price (with some adjustments). Taxpayers can avoid paying capital gains tax simply by holding on to their assets until they die (or by donating appreciated assets to charity).
Under current law, the basis of assets held until death is “stepped-up” to the asset’s market value at the time of death, allowing an heir to sell the asset without owing any tax on what may be years of unrealized capital gains. So, for example, suppose an investor buys stock at $2 a share and it’s worth $10 a share at the time of death. If an heir later sells it for $13 a share, tax is paid on the $3 per share increase in value since the investor died rather than the $11 increase in value above its original purchase price.
As long as the estate tax remains part of the tax code, it serves as a kind of back-stop to the income tax for the wealthiest decedents. A 2014 study by the Treasury department shows that unrealized gains account for almost half of the fair market value of estates. But the House bill would repeal the estate tax entirely in 2025 and keep the step-up in basis. Thus, income from the increased value of assets that is passed on to heirs wouldn’t be taxed either as capital gains or as part of the estate. It simply wouldn’t be taxed at all.
Even with a capital gains tax rate that is substantially lower than the tax rate on ordinary income, people who can pass assets to heirs tax free would have a strong incentive to hold them while they are still living and avoid tax on a large share of their income. According to an IRS study of 2008 estate tax filings, capital gains made up about 40 percent of married filers’ income the year before their death.
If those gains were passed on to heirs that income would be tax free. As a result, capital gains tax collections could fall significantly. Because capital gains are concentrated at the top of the income distribution—among the same people likely to benefit from repeal of the estate tax—that decline is likely to be substantial. According to the IRS, in 2015 more than one-third of all capital gains were realized by those with adjusted gross incomes of at least $20 million.
If Congress wants to repeal the estate tax, there are approaches to address this problem of allowing capital gains to escape taxation forever. For the largest estates, capital gains could be taxed at the time of death by essentially requiring the value of assets to be “marked to market” at that time. Donald Trump backed this idea during his presidential campaign. Large estates would still pay less tax than under current law for two reasons: First, the capital gains tax applies only to the value of an asset above its basis while the estate tax applies to the asset’s entire gross value. Second, the top capital gains tax rate would be about 24 percent while the estate tax rate is 40 percent. However, calculating the market value of some assets, such as rare works of art, might be difficult, which could lead to disputes.
Alternatively, the basis could be “carried over”, meaning that if an heir sells an asset, she pays tax on the difference between its sale price and the original basis. Critics once opposed this method because, they noted, it was often difficult to calculate basis. But now calculating original basis is relatively easy for publicly-traded securities (though it may be more complicated for some other assets). And even if the basis is set at zero for assets where there are no records of original basis, the heir still faces a tax rate below 25 percent rather than the current 40 percent estate tax rate.
With either approach, Congress could repeal the estate tax and still make sure that a large source of income for the richest families does not escape taxation entirely.
Posts and comments are solely the opinion of the author and not that of the Tax Policy Center, Urban Institute, or Brookings Institution.
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