Impacts of recent Capital Gains law proposal

[pbspelly]

I've never understood the justification for the stepped-up basis, particularly for things like stocks. Someone gives you stocks they bought for $5000 that are worth $10,000 when they give them to you, and you sell them for $10,000, you owe capital gains on the $5,000 gain. Someone dies and leaves the same stocks to you in their will, and you sell them for $10,000, you owe nothing on the $5000 gain. Why does their death wipe out tax liability for the $5000 gain? I'm not a tax lawyer, and maybe there is some justification, but I don't see it.

Likewise, the carried interest treatment for hedge fund manager income has always seemed like a huge loophole to me.

[Exhibitman]

Originally Posted by pbspelly

I've never understood the justification for the stepped-up basis, particularly for things like stocks. Someone gives you stocks they bought for $5000 that are worth $10,000 when they give them to you, and you sell them for $10,000, you owe capital gains on the $5,000 gain. Someone dies and leaves the same stocks to you in their will, and you sell them for $10,000, you owe nothing on the $5000 gain. Why does their death wipe out tax liability for the $5000 gain? I'm not a tax lawyer, and maybe there is some justification, but I don't see it.

Likewise, the carried interest treatment for hedge fund manager income has always seemed like a huge loophole to me.

As to the former, the justification is that the government has already had its bite at that money via the unified tax credit. When you die right now you can pass the first $11.7 million tax-free. After that you pay estate tax. The asset has already been 'taxed' when it passes, with valuation at fair market value, so the idea was that the G doesn't get a second bite at the asset at the decedent's basis when the heir sells it.

As to the latter, it is total BS: there is no reason other than good lobbying on the part of the rich for earned income to be taxed at a higher rate than any other income. The idea of investment being encouraged is crap; no one who builds a business does so based on taxes, except the accountants who file them.

[pbspelly]

Originally Posted by Exhibitman

As to the former, the justification is that the government has already had its bite at that money via the unified tax credit. When you die right now you can pass the first $11.7 million tax-free. After that you pay estate tax. The asset has already been 'taxed' when it passes, with valuation at fair market value, so the idea was that the G doesn't get a second bite at the asset at the decedent's basis when the heir sells it.

As to the latter, it is total BS: there is no reason other than good lobbying on the part of the rich for earned income to be taxed at a higher rate than any other income. The idea of investment being encouraged is crap; no one who builds a business does so based on taxes, except the accountants who file them.

So the government has already had its first bite, but only if the estate is worth more than $11.7 million. Otherwise there is no bite at all, right? Maybe they should eliminate the step-up basis unless the asset was taxed as part of an estate that exceeded $11.7 million. The main argument against an estate tax is that the decedent already paid taxes on those earnings or property during his or her lifetime. So it isn't fair for the government to tax the same thing twice. But that wouldn't apply for unrealized capital gains, right? Taxes have never been paid on that, and with the step up basis, they never will. I'm sure there are complications and stuff I am not seeing, but it seems to me that this is a loophole.

[Exhibitman]

Originally Posted by pbspelly

So the government has already had its first bite, but only if the estate is worth more than 11.7 million. Otherwise there is no bite at all, right? Maybe they should eliminate the step-up basis unless the asset was taxed as part of an estate that exceeded $11.7 million. The main argument against an estate tax is that the decedent already paid taxes on those earnings or property during his or her lifetime. So it isn't fair for the government to tax the same thing twice. But that wouldn't apply for unrealized capital gains, right? Taxes have never been paid on that, and with the step up basis, they never will. I'm sure there are complications and stuff I am not seeing, but it seems to me that this is a loophole.

Absolutely, it is a loophole, but one that has a practical purpose to it: the credit is designed not to force the heirs to highly appreciated residences, farms or smaller businesses to sell off the assets to pay taxes. Used to be $3.25 million but was jacked up and indexed to inflation. The UK, by contrast, taxes inheritances worth more than 325,000 pounds unless left to a spouse or charity, which forces lots of heirs to sell off the family jewels, family home, family business, or family land, to pay it. It is also why so many of the historic estates either have been gifted to the National Trust or opened commercially to pay the inheritance tax. When our estate tax was pegged low, it was not unusual for many people who you would think of as average middle class or professional class to have to engage in all sorts of machinations (bypass trusts, irrevocable life insurance trusts, etc.) to find ways around the estate tax because a nice home in a desirable area, a decent retirement savings, plus any other sort of asset and a life insurance policy would trigger taxation. It also bred a lot of cheating: offshoring funds, cash and hard asset holdings with 'five finger discounts' to heirs with access to safe deposit boxes, and so on.

[pbspelly]

Maybe I'm being obtuse, but I still don't quite see the reason for the step-up rule. Why not simply have a rule that heirs only have to pay the capital gains tax when they sell the asset? You inherit a stock worth $100,000 with a basis of $25,000, you don't have to pay any estate or inheritance tax (or it falls under a generous $11.7 limit), but if you sell the stock you have to pay tax for the $75,000 gains.

I personally benefited from the step-up rule when my father passed away, and I'll admit I did not voluntarily give the government any money. But even then I recognized that there was something wrong with the law. From a tax perspective, several years of capital gains on some stocks was just erased as if they had never happened.