The U.S. has one of the greatest wealth gaps of any developed country in the world.[1] As the nation with the most billionaires[2] and the highest GDP,[3] the U.S. has a shamefully high poverty rate, with 11.5% of the population (37.9 million people) living in poverty.[4] Solving this problem will require varied and multi-dimensional strategies, but one perennial piece of the solution that is unlikely to change is the need for funding. One place to start is by closing some of the most egregious loopholes in the tax code, which allow billions of dollars to escape taxation each year – dollars that could be put towards funding social programs in the form of nutrition, healthcare, early childhood education, the child tax credit and more.

One such loophole is stepped-up basis at death. Little-understood among the American public, this loophole allows the wealthy to collectively pass billions of dollars in capital gains on to their heirs, completely untaxed.[5] It’s been estimated that closing this loophole could pull in $100-200 billion dollars over a ten-year period.[6]

So, what is stepped-up basis at death? Imagine a person buys stock for $1,000. This amount is known as their basis in the stock; all gains will be measured in relation to this value. Let’s say after a number of years, the stock value has grown to $5,000. If this person sells their shares now, they will be taxed, at a preferential capital gains rate, on the $4,000 gain (the difference between the $5,000 current value and the $1,000 basis). However, because the U.S. tax code does not tax gains until they are realized (i.e., sold, in this case), if this person holds on to their shares, they will pay no tax at this time.

Now, imagine that this person continues to hold their shares for several more decades, at which point the value of their stock has grown to $100,000. If they were to sell at this point, they would be taxed on the $99,000 gain that has accrued since they first bought the stock. If, however, they instead hold the shares until they die, passing them on to their heirs, they are not taxed on this gain. Shockingly, neither are the heirs. As the new owners of the stock, the heirs assume its fair market value (in this case, $100,000) as their basis, rather than the $1,000 for which it was originally purchased. This means that no one is ever taxed on the $99,000 gain. Because the new owners of the shares adopt the current market value as their basis, this is the starting point from which any future gains will be measured. So, if the shares increase in value to $130,000 and the new owners sell, their gain will only be $30,000. This means that for tax purposes, it is as if the massive accrual in value during the first owner’s lifetime never occurred.

It is worth thinking about whom this affects. Intuitively speaking, one must have substantial resources to invest in the first place. One must be even more well-off to be able to hold on to those investments indefinitely, without ever needing to cash them in, simply to avoid paying taxes. Unsurprisingly, the data bears this out: the Congressional Budget Office (CBO) estimated that in 2019, 56% of the benefit of stepped-up basis went to the top 20% of the income distribution, with 18% going to the top 1% alone.[7]

It’s hard to come up with a good justification for keeping this loophole in the tax code, on either rational or moral grounds. Given the basic principle that we tax most forms of income, including capital gains, this exclusion doesn’t make much sense on its face. Eliminating it would allow the government to collect revenue on income that logically should be taxed and reduce one of many asymmetrical benefits in our tax code that skew towards the wealthy. Some have argued, however, that to tax capital gains upon death would be to duplicate the estate tax.[8] But in 2024, only estates worth $13.6 million or more are subject to the estate tax.[9] So, this does not affect the vast majority of people. And for those wealthy enough to be affected, we might ask whether there is anything implicitly wrong with facing both taxes. Many Americans might not think it is so crazy for multi-millionaires to be taxed on the value by which their assets have increased over their lifetimes, as well as being taxed, separately, under the estate tax.

In addition to the increased revenue generated directly from ending stepped-up basis, there would be another benefit: this change could open the door for an increase in the tax rate for capital gains. One of the main reasons cited for not raising the rate (which is currently 20% for the highest income brackets,[10] as compared to 37% for ordinary income), is that it incentivizes a phenomenon known as “lock-in.”[11] The idea is that if capital gains rates are hiked up too much, rather than selling or otherwise disposing of their investments, individuals will hold on to them until they die, passing them on to their heirs and evading taxation as explained above.[12] However, if we eliminated stepped-up basis, this option would disappear. Therefore, implementing these two changes in tandem could unlock new revenue in two ways: taxing the capital gains that were previously untouchable and taxing all capital gains at higher rates.

In 2021, the Biden Administration planned to do just this, as part of its proposed American Families Plan, which would have provided funding for “education, childcare, health care, and paid family leave.”[13] The cost of these programs would have been partially offset by eliminating stepped-up basis at death (with a $1 million exemption per person), and increasing the capital gains rate for taxpayers earning more than $1 million each year to Biden’s proposed ordinary income rate of 39.6%.[14] The Treasury Department estimated these changes together would raise $322 billion over ten years.[15] In 2023, the Administration again proposed similar changes to the tax code.[16]

These proposals have been unsuccessful thus far. But if we are serious about addressing poverty, it is imperative that we keep pushing for reform, or all-out elimination, of provisions in the tax code that exacerbate wealth inequality. Stepped-up basis at death, which Elizabeth Warren has called “low-hanging fruit,” is a prime example. [17] These reforms represent a relatively straightforward way to raise billions of dollars in additional revenue, which could be used to fund antipoverty programs like the ones in Biden’s proposed American Families Plan. While obviously more is needed on so many fronts to solve the issue of poverty in the U.S., eliminating stepped-up basis at death could be a good place to start.

 

[1] Anshu Siripurapu, The U.S. Inequality Debate, Council on Foreign Relations (last updated Apr. 20, 2022),  https://www.cfr.org/backgrounder/us-inequality-debate.

[2] Dean Sean Martin, The Countries with the Most Billionaires 2024, Forbes (Apr. 2, 2024), https://www.forbes.com/sites/devinseanmartin/2024/04/02/the-countries-with-the-most-billionaires-2024/?sh=2714b2e54f87.

[3] Tim Smart, The 10 Largest Economies in the World, U.S. News & World Report (Feb. 22, 2024), https://www.usnews.com/news/best-countries/articles/the-top-10-economies-in-the-world#:~:text=The%20United%20States%20is%20the,the%20economies%20of%20the%20world.&text=America’s%20gross%20domestic%20product%20in,largest%20economies%2C%20Japan%20and%20Germany.

[4] National Poverty in America Awareness Month: January 2024, U.S. Census Bureau (Jan. 2024), https://www.census.gov/newsroom/stories/poverty-awareness-month.html#:~:text=The%20official%20poverty%20rate%20in,decreased%20between%202021%20and%202022.

[5] See The Distribution of Major Tax Expenditures in 2019, Cong. Budget Off. (Oct. 2021), https://www.cbo.gov/publication/57585#_idTextAnchor024.

[6] What is the Stepped-Up Basis and Why Does the Biden Administration Want to Eliminate it? Peter G. Peterson Found. (June 21, 2021), https://www.pgpf.org/blog/2021/06/what-is-the-stepped-up-basis-and-why-does-the-biden-administration-want-to-eliminate-it; The Biden Tax Plan: Budgetary, Distributional, and Economic Effects, Penn Wharton Budget Model, (last updated Sept. 2020), https://budgetmodel.wharton.upenn.edu/issues/2020/1/23/the-biden-tax-plan.

[7] The Distribution of Major Tax Expenditures in 2019, supra note 5.

[8] John Egan, What is Step-Up In Basis? Forbes Advisor (Mar. 28, 2023), https://www.forbes.com/advisor/investing/what-is-step-up-in-basis/.

[9] Estate Tax, IRS (Nov. 27, 2023) https://www.irs.gov/businesses/small-businesses-self-employed/estate-tax.

[10] Under current law, an additional 3.8% tax is assessed on the net investment income, including capital gains, of most taxpayers with income above certain thresholds (e.g., $200,000 for single taxpayers or heads of household). Find Out If Net Investment Income Tax Applies to You, IRS (Feb. 7, 2024), https://www.irs.gov/individuals/net-investment-income-tax.

[11] Topic no. 409, Capital Gains and Losses, IRS (Jan. 30, 2024), https://www.irs.gov/taxtopics/tc409; Federal Income Tax Rates and Brackets, IRS (Mar. 18, 2024), https://www.irs.gov/filing/federal-income-tax-rates-and-brackets; Michael J. Graetz & Anne L. Alstott, Federal Income Taxation: Principles and Policies 138, (9th ed. 2022).

[12] Graetz & Alstott, supra note 11; Some economists have determined that increasing the capital gains rate beyond 30% would lead to revenue loss for this reason. Closing the Stepped-Up Basis Loophole, Comm. for a Responsible Fed. Budget (Sep. 9, 2021), https://www.crfb.org/blogs/closing-stepped-basis-loophole.

[13] What’s in President Biden’s American Families Plan? Comm. for a Responsible Fed. Budget (Apr. 28, 2021), https://www.crfb.org/blogs/whats-president-bidens-american-families-plan.

[14] Closing the Stepped-Up Basis Loophole, supra note 12.

[15] General Explanations of the Administration’s Fiscal Year 2022 Revenue Proposals 105, U.S. Treasury Dept. (May 2021), https://home.treasury.gov/system/files/131/General-Explanations-FY2022.pdf.

[16] Cheryl Winokur Monk, The Biden Tax Proposals that Could Hit Baby Boomer, Family Businesses, CNBC: Small Business Playbook (last updated Apr. 29, 2023), https://www.cnbc.com/2023/04/29/the-biden-tax-proposals-that-could-hit-baby-boomer-family-businesses.html.

[17] Taylor Tepper, What Investors Should Learn From The Failed Bid To End Stepped-up Basis, Forbes Advisor (Sep. 21, 2021), https://www.forbes.com/advisor/investing/stepped-up-basis-lessons/.