The stepped-up basis for our children is under attack. The Biden administration wants to either abolish the stepped-up basis altogether or alter it to generate more tax dollars. If heirs are then forced to pay a capital gains tax upon inheriting an asset, despite not selling, this could have negative consequences for families and the economy.
The stepped-up basis is a way of adjusting the tax rate paid on capital gains, which may be hiked for those who make over $1 million in combined income and capital gains. Although paying a capital gains tax rate of 39.6% + 3.8% NIIT tax may sound like a lot, eliminating the stepped-up basis would be far worse. The stepped-up basis applies to investment assets passed on after death.
When someone inherits capital assets such as real estate, stocks, bonds, or a small business, the IRS “steps up” the cost basis of these properties to the current “fair market value.” Fair market value is easier to determine for publicly traded assets. However, deciding the fair market value for real estate, private equity, or a small family business is much more subjective.
Under current tax law, when an inherited asset is sold, the inheritor only pays tax on any profits calculated from the day they inherited it. Therefore, if the asset value is stepped up to its current market value and immediately sold, the heir doesn't have to pay any capital gains tax.
Let's first go through an example of a stepped-up basis and then the risks of relying on the stepped-up basis to pass down assets. Then I'll share some examples demonstrating why we need to preserve the stepped-up basis for our children. If you are an estate planner or tax lawyer, please chime in!
Example Of A Stepped-Up Asset With Stock
Let's say Jim dies and leaves $100,000 worth of Apple stock to his son, Junior. Jim bought Apple stock years ago and his cost basis is $10,000.
The IRS resets Junior's cost basis to $100,000 given that is what his Apple holding is worth today. Therefore, if Junior decides to sell Apple stock as soon as he gains ownership, Junior would pay zero capital gains tax. Transferring stock to Junior is the tax-efficient way to go.
If Jim had decided instead to take profits on Apple stock and sell at $100,000, he would have had to pay a 15% capital gains tax on $90,000. His tax bill would be $13,500, which would leave proceeds of $86,500.
Therefore, if Jim's ultimate goal was to give his son his Apple stock, it would be best for Jim to hold on until death. After all, $100,000 is greater than $86,500.
Using stocks is the least contentious example for removing the stepped-up basis. Stocks don't take work to own or operate. There is little-to-no sentimental value with stocks. And stocks can easily be sold to pay for a tax liability.
Risks Of Using The Stepped-Up Basis To Pass Down Assets
There are four risks to relying on the stepped-up basis as a means to pass down assets tax-efficiently.
1) Asset Could Decline
In the example above, transferring assets through the estate upon death is more tax efficient. However, if Apple stock had declined by greater than 13.5%, Junior would be left with less than $86,500 worth of Apple stock. Therefore, it would have been better if his father took profits when Apple was worth $100,000 and paid the tax. At least Junior still doesn't need to pay capital gains taxes thanks to the stepped-up basis rule.
However, what if there was no stepped-up basis? Junior has to pay the $13,500 in tax and holds on. If Apple stock then proceeds to plummet, Junior's inheritance declines even further.
Let's say Junior inherited a highly speculative asset that went to $0 after paying the capital gains tax on a $90,000 gain. Junior would actually end up losing $13,500 to the IRS thanks to his inheritance.
2) The IRS Might Disagree With Your Fair Market Value
Imagine owning a small business without a lot of close comparable sales. Without a previous sale of another business, it's hard to value the business's true worth. Therefore, the IRS may assign a lower fair market value to the business you inherit. That's good for the estate. However, if you decide to sell the business one day, you would owe more in capital gains.
Therefore, it is up to the estate to try and value the small business as high as possible as long as it is under the estate tax threshold. This way, your heirs can pay a lower capital gains tax if the stepped-up basis is ever abolished.
3) You Don't End Up Fully Utilizing Your Wealth
Another risk of relying on the stepped-up basis as a means to pass down assets is not using enough of your money to pay for a better life. If you never sell an asset, you will never incur a capital gains tax, no matter how profitable the investment is. If your estate transfers less than $12.6 million in assets to your heirs per person, your estate will never have to pay a death tax either.
Given only around 0.1% of estates pay a death tax (estate tax) each year, the vast majority of Americans are golden. However, the whole purpose of working, saving, and investing is to one day enjoy your wealth. Not enjoying your wealth more in order to avoid capital gains taxes is letting the tail wag the dog.
Money should be spent. Otherwise, there's no point working and saving so much.
4) Leaving Your Kids Too Much Money
Given the median life expectancy is around 80, and the median age of new parents is around 30, the median age for people receiving an inheritance is around 50. However, leaving your middle-aged children a large inheritance is a suboptimal move.
Few 50+-year-olds need a large inheritance to survive. After 32+ years of work after high school or 28+ years of work after college, most 50+-year-olds should be self-sufficient. Your kids may lose motivation to make something of themselves. Further, your kids might feel guilty for inheriting so much.
Inheriting lots of money when someone already has money won't be as appreciated. Therefore, it would have been better if parents spent more of their money or gave more money to their kids while they were younger.
Why We Should Preserve The Stepped-Up Basis
Imagine a 200-acre family farm in Iowa and the original owner with a low basis dies. The farm is worth $5 million and was purchased for $200,000, 60 years ago. The farm generates about $800,000 in annual operating profits. Without the stepped-up basis, the five inheritors will have to pay about $1.9 million in capital gains tax to keep the farm, if the government forces the inheritors to pay a capital gains tax upon transfer of assets.
But how are the five inheritors, who are regular middle-class farmers making $60,000 a year going to come up with $1.9 million to pay for the capital gains tax? Even divided among five people evenly, that's $380,000 each in capital gains tax under the proposed higher rate.
Despite the farm being in the family for multiple generations, sadly, the heirs decide to sell the farm to pay for the capital gains tax. If they don't pay the tax, the government will confiscate the land and the business.
The heirs then split the $3.1 million five-ways. Their family legacy and all the sweat equity their grandparents put in are now gone forever. The buyer decided to turn the farm into strip malls.
If there was a stepped-up basis, the inheritors would receive the farm with a cost basis of $5 million. Therefore, there would be no need to pay a capital gains tax or sell the property. The heirs would be incentivized to improve the value of the farm and feed more people. Any value created after the stepped-up basis would then be taxed by the new heirs.
But as you can imagine, someone may eventually have to pay the tax, even if the farm is never sold. If the farm keeps appreciating, it may eventually push the estate over the estate tax threshold at the time. If so, the estate would pay the tax upon death of the estate owner.
How Removing The Stepped-Up Basis Hurts Potential Home Buyers
A Financial Samurai reader shares an example of how removing the stepped-up basis would decrease housing inventory. I've edited his example for clarity and accuracy.
I am someone who received the stepped-up basis two years ago. I'm contemplating selling one of the properties to potentially live where I want to live rather than my current home. Because of the new tax basis, selling would be feasible since I can afford the amount of capital gains tax.
Without the new stepped-up basis, selling to buy a new home where I want to live would be a non-starter. Let me explain why with an example. In 1978, parent buys a property in San Francisco, CA for $200K. The property is now valued at $3.5M.
Son wants to move to San Diego and would like to sell the property to help finance the purchase of a new home. Without the stepped-up basis, the son would incur capital gains taxes on $3.3 million in profits, or about $1.2 million in tax. The son would be left with $2.3 million before paying commission and transfer taxes. To trade a $3.5 million home for a $2.3 million home makes no sense.
Such being the case, few if any people would sell unless they absolutely had to. Instead of selling, the heir would probably rent it out and maybe finance a new home purchase, thus keeping housing inventory low and locked in for generations.
Stay long real estate, especially if the stepped-up basis gets removed.
How Removing The Stepped-Up Basis Hurts Families
Let's say your parents die and leave you your childhood home. You grew up in it for 18 years and have been going back to visit your parents for 50 years. Your children have enjoyed visiting their grandparents for 15 years. The sentimental value of the home is enormous. Therefore, you want to keep the $3.5 million home. To you, it's still a $200,000 home your parents bought ages ago.
You'd like to remove the popcorn ceiling, remodel the kitchen and bathrooms, install new windows, and fix all the dry rot. You have great plans to make the home great again!
Unfortunately, with the removal of the stepped-up basis, you cannot afford to pay a $1.2 million tax bill and keep the home at the same time. Even if you had $1.2 million, it would likely be tied up in investments that would incur a capital gains tax if you sold to pay your inheritance tax bill.
If all you had was $1.2 million, you would end up with 100% of your net worth in your childhood home. That's bad net worth diversification. The stepped-up basis puts your family at financial risk if there is a economic downturn in your area.
Your only choice is to sell the home, pay the $1.2 million tax bill, and watch some other family take over your family's home. So sad! You dreamed of growing old in your parent's home and having your kids and your grandkids come to visit one day as well. Alas, thanks to no more step up, your dream is dashed.
Some of you might be thinking that having $2.3 million in net proceeds is enough to buy a new dream. But what good is money if you can't buy the property and lifestyle you want? To many families, the sentimental value is priceless.
How Removing The Stepped-Up Basis Hurts Small Businesses
According to the JP Morgan Chase Institution, over 99 percent of America's 28.7 million firms are small businesses. The vast majority (88 percent) of employer firms have fewer than 20 employees. Meanwhile, nearly 40 percent of all enterprises have under $100k in revenue.
It is clear small businesses are the backbone of the American economy. Removing the stepped-up basis hurts small business owners for taking risks and trying to provide a better life for their children. Even if the capital gains tax isn't required to be paid immediately upon inheritance, eventually, it may have to be paid.
Imagine you are a first-generation immigrant and a minority. You come to America for the opportunity. However, due to your poor English skills and lack of connections, you can't land a well-paying job. Therefore, you open up a bodega. For the first 20 years, you worked 16-hour days. You borrowed money from friends and family to open your first store. Over time, your store becomes a community fixture.
30 years later, you have expanded to five bodegas in your city. Each bodega generates an operating profit of $100,000 a year. You now work a more manageable 9-hour day. Your two children are managing the five bodegas, regularly working 12-hour days. They are in charge of training, inventory management, procurement, and bookkeeping.
Conflicting Cost Basis
When you pass, the IRS values your five stores at 6X operating profit, or $4 million. But what is the true cost basis of all your bodegas? It's hard to say. Maybe the first bodega was valued at just $1,000 because you had to borrow everything to get it started. You didn't own the land or the store. Perhaps the combined value cost basis of the five bodegas is only $500,000. Your estate fights to value the cost of all bodegas at closer to $2 million, but lose.
As a result, your two children will have to pay about $1.2 million in taxes on $3.5 million in profits. Instead of keeping your family business and legacy alive, your children have no choice but to sell a couple stores to pay for the capital gains tax bill.
Small businesses are already declining as a percent of GDP. Removing the stepped-up basis will cause more small businesses to disappear. That is no good for immigrants, minorities, those with less formal education, and entrepreneurs of all types.
Focus On Who Pays The Tax (Estate Or Heir?)
When it comes to paying the estate tax, the estate pays the tax if it is over the estate tax threshold, not the heir. By abolishing the stepped-up basis, the heir ends up paying a capital gains tax regardless of the estate tax threshold. If the estate is under the estate tax threshold, then having the heir pay a capital gains tax would defeat the purpose of having an estate tax threshold.
Currently, only if the heir receives an inheritance in a state that has an inheritance tax, will the heir pay a state inheritance tax.
But should the heir have a tax liability for receiving something he or she may never have asked to receive? Depending on the inherited asset and the heir's own financial situation, the heir could be put in a difficult decision on what to do with the asset.
If the heir did not want the asset in the first place, the logical move would be to sell off the inherited asset to pay for the capital gains tax. This, in turn, hurts the continuity of the community and small businesses everywhere.
To then impose a capital gains tax on an heir who wants to keep the asset, but has no way to pay for a large capital gains tax bill would be a crying shame. Without the financial means to pay for the capital gains tax liability, the heir may have to sell off the asset or mortgage his future.
The government is essentially waiting for you to die or give up on your business dream in order to tax you again. That’s not very motivating to start a business, take risks, or work harder to grow a business. By removing the stepped-up basis, that is a negative signal for small business owners.
Related: Never Sell Assets And Pay Less Taxes Like Billionaires
A Stepped-Up Basis Compromise: Different Rules For Different Assets
If the government really wants to alter the stepped-up basis, the government should have separate rules for types of assets.
For example, if the transferred asset is impersonal and fully fungible, such as stocks, bonds, and cash, then removing the stepped-up basis is more palatable. The heir can easily sell of the financial windfall, pay the capital gains tax bill, and still have money left over. There is no sentimental value to holding such assets.
However, if the transferred asset is an illiquid asset that can't be easily liquidated, such as a family business, then the government should keep the stepped-up basis. The same goes for removing the stepped-up basis for an inherited family home. At the very least, the government should raise the dollar amount threshold before heirs are forced to pay a capital gains tax to cause less disruption.
If we want to promote entrepreneurship, the long-term holding of assets, and support families, we should preserved the stepped-up basis. After all, the American Families Plan is supposed to help families not hurt families.
Taking calculated risks and working hard are the two main things all of us can control. How far we get is mostly due to luck. At the very least, the government shouldn't force heirs to pay a capital gains tax if the heirs do not sell the asset.
My Goal To Keep A Small Business Going
I plan to keep Financial Samurai going for a couple more decades as I enjoy writing. However, I'm also incentivized as a father to provide career insurance for my children.
I'm positive competition to get into good universities and land solid jobs will be even more fierce in the future. As someone with little-to-no status, I can't use nepotism or connections to help my children find gainful employment. As a minority, perhaps my children will have less opportunities as well.
Therefore, I soldier on as a small business owner, even though I desperately want to re-retire. And if my kids are forced to sell Financial Samurai after I spent more than 32 years writing on the site, I will be pissed! Some of my family entries are priceless, especially as they age. For the new owner to turn this site into an impersonal affiliate site would be such a damn shame.
But what other choice will my kids have if they have to pay millions in taxes without the stepped-up basis upon inheritance? If they absolutely don't love to write and free from a typical 9-5 job, would they be willing to keep FS going?
Will my kids be able to fight the temptation of selling their father's legacy if someone offered them, say, $20 million? After all, they weren't the ones who put in all the time and effort to create this site. Even if they had to pay a total effective tax rate of 50%, that still leaves them with $10 million.
For me, I would find paying $10 million in taxes to be an absolute economic waste. To them, they might think what's the big deal since they'll be $10 million richer. It wasn't their money in the first place. Besides, they read on Financial Samurai that $10 million is the ideal net worth figure to retire!
Helping All Families Prosper
Trying to raise the capital gains tax rate to 43.4%, the top federal marginal income tax rate to 39.6%, and the corporate tax rate to 28% is already good enough. I'm most excited about the American Families Plan providing paid parental leave and subsidized childcare.
However, let's save the stepped-up basis for the good of more American families. Small businesses owners are significant employers and vital for the American economy. Having a stepped-up basis encourages hard work.
Forcing heirs to sell off family businesses to pay an unnecessary capital gains tax is a self-inflicted wound. Even if heirs don't have to pay the capital gains tax immediately, someone may eventually.
When it comes to families, let's help all families thrive.
Related posts:
Three Things My Estate Lawyer Said Everyone Must Do
The Benefits Of A Revocable Living Trust
The Best Time To Retire May Be Under A Democratic President
Readers, what do you think about the stepped-up basis? Why does everyone think the stepped-up basis only affects the really rich? What kind of solutions do you have for illiquid assets and small business owners if the stepped-up basis is removed?
Disclaimer: I'm not a tax attorney and don't play on on TV. But I am a tax enthusiast. Find a tax professional or estate planning lawyer to help you with your estate planning issues.
For more nuanced personal finance content, join 100,000+ others and sign up for the free Financial Samurai newsletter. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009. Everything is written based off firsthand experience.
interesting post!
Very informative article. Our family is in an interesting situation. Wondering if this forum can bring some suggestions.
Our father had many acres of farm land that he kept rented out. He passed away in 2001 and his will stated the land goes to all 6 children (equal shares) with the caveat that while our mother was living, all earnings from the rented land would go to her and land could not be sold during this time – until she passed.
She passed early this year. It’s been 20 years since he passed. During the 20 years, we could not sell or receive rent money for the land.
All siblings agreed to sell now.
Which “date” would the step up basis be from? From the date of dad’s passing or mom’s?
Doing away with the stepped up basis at death does not necessarily mean inheritance would be a taxable event. So your sad story about the farmer’s children is fiction. The inheritors could hang on to the farm as long as they liked and pay no taxes until and unless they sell it – the same rules their parents lived by when they were alive.
“if the government forces the inheritors to pay a capital gains tax upon transfer of assets.”
Sooner or later, the farm will be sold. And when it does, the government will unfairly tax at a cost basis future generations have never seen.
Absolutely! the child will receive the property tax break. However, he or she will not get the step-up in basis, which is a huge tax break for highly appreciated homes
Hi Sam!
Great article as always. A couple of comments.
You mentioned: But how are the five inheritors, who are regular middle-class farmers making $60,000 a year going to come up with $1.9 million to pay for the capital gains tax?
Response: What is stopping them from taking a loan out against the property? There is no mention of this in your article. The same question should be brought up regarding the other topics. Like a family business.
My biggest issue with Bidens’ plan is that he is trying to collect more money to spend more money instead of paying down the government debt and fixing the issues his predecessors have created.
Another issue I have with Bidens’ plan is that he set’s artificial numbers on how much someone needs to earn before the tax takes effect. There is no mention of what the value will be in the coming years. In other words, more and more people will fall into that tax bracket over time.
Nothing. They can each spend more money and time to try and take out a loan to pay a capital gains tax that goes to the government. Then they’ll pay interest on a loan over however number of years. More calculations need to be involved. Good for lenders I guess. Not great for heirs who have another hurdle to jump over.
And what if one or two can’t get a loan? The 5 are all in it together. If two can’t come up with the money, then they might be forced to sell or get penalized by the government. Complicated. So complicated, which is why the tax industry loves it. More money to earn.
Interesting how everyone thinks a loan is such an easy panacea. Not surprising, since majority of voters are employees (often not senior management-try explaining to CFO you want company to take a loan to support your new department or invest in systems) and not business owners.
Many businesses already operate with some leverage. The decision whether to borrow comes down to the financials, but often, it should best be a calculated risk to grow the business. You might have to invest in new technologies in the future, secure more inventory (and therefore market share), need capital for overhead to support a new revenue stream/business, etc. Taking a loan to pay CGT immediately starts you off with some serious headwinds to run in place, lowering your margins. Parents may have some deferred maintenance or not invested in new technologies to remain competitive that the next gen needs to invest to stay relevant.
Lastly, for small businesses, even an LLC, lenders will want a personal guarantee and not all family members have the credit/score to secure, leaving one or two to shoulder the burden.
Boil it down more personally. If your life was your “business,” as in Retirement, LLC, and you’ve budgeted your expenses and cashflow, 4% rule, etc. and get handed this huge tax bill, how would you like to pile on the debt to maintain what you’ve built?
What happens if a business, for example, while having a low basis and relatively gross high value is highly leveraged (maybe had some tough years so had to finance operating expense) and there isn’t even enough value in the company to pay the tax bill?
Lose the business or get taken under.
It is not easy running a business sometimes. More headwinds.
Sam, well argued points and I agree with you. With this said, what do you suggest the government do to pay for all the spending they are doing (as an alternative)?
Stop spending
Exactly. Government income has gone up 4% a year since 2000, including under tax cut Trump, but spending has averaged 6% growth per year, which is the opposite of what should happen with benefits of scale as both the economy and population grow. We are very close already to the laffer curve maximization of taxes (and don’t give me higher rates of 50s, 60s, etc – there were so many easy deductions millionaires weren’t paying taxes! Which is why the AMT was added)
Try to spend more within budget like any normal person or household would.
The gov’t is already trying to raise capital gains tax and the marginal income tax rate.
The step up basis is a loophole that needs to be closed to fairly capture and tax capital gains upon sale not upon transfer at death. Otherwise if you don’t get rid of the step up basis then the gains are never taxed. Why would that be fair? Its just a loophole let us be honest. It is just a way to avoid capital gains tax.
I don’t think it’s fair to describe it as a loophole at all. It’s an intentionally designed aspect of the tax code that has been around for generations. Most of the gains on things like real estate that’ve been held for decades are just inflation gains anyhow. While there are some exceptions (e.g., California), real estate generally just appreciates at the rate of inflation. If stepped up basis at death is disallowed, then the tax basis should at least be allowed to adjust over time with inflation.
Also, against all this backdrop is the state and federal estate taxes which is going to catch the truly wealthy anyhow, even with stepped up basis.
Agree, it’s not a loophole.
What about a situation if $10 million is faced with an estate tax of 40%. The $6 million is given to someone with a cost basis of $1 million. Are people arguing the $5 million then needs to pay a capital gains tax as well?
I think a fair number of people advocating sweeping tax code changes are in fact arguing for that. I also think it’s unfair to change the deal of stepped up basis at death after people having literally been relying on it their entire adult life. Most people don’t keep records to show tax basis for things they never intend to sell.
This really boils down to whether you want to believe that the U.S. is a bootstrap nation or an aristocracy. If you like to believe in entrepreneurship, economic efficiency, and a modicum of a meritocracy, you should consider eliminating stepped up basis as a good thing to help eliminate the massive and growing wealth inequality.
In an ideal world, I would prefer we retain a choice donate to a philanthropy of choice rather than be taxed to oblivion or give untold riches to our children. Of course, this is not an option by our politicians who are under the gun to increase revenues.
There is a fine line between being incentivized to provide a good life for your child via helping with tuition and perhaps a first home and bestowing upon your children a massive inheritance. This line is a very subjective and contentious line to draw of course.
I’m intrigued at the opposition to such stepped up basis as it seems like folks believe their own children cannot achieve what they themselves did. In fact, statistics show that generational wealth often dissipates by the third generation – implying that, despite the inheritance, connections, and being born on third base, it seems as though the security of wealth is detrimental to the motivation of the children and grandchildren. Indeed, I have observed this first hand in many instances of children of the wealthy here in the Bay Area.
Let’s take for example a self made billionaire like Bezos, currently worth $>201 billion. I have no issue with a founder / CEO acquiring such wealth and do not think a founder CEO should be taxed higher in marginal tax rates. However, do we really believe his children should receive billions simply for winning the lottery? Do we believe that economically his children will provide the same value to society as a whole?
I don’t think many people are arguing against the Jeff Bezos of the world not paying an estate tax or his heirs paying an inheritance tax.
The argument is on removing the step up basis for small businesses owners and their children.
It’s already hard enough to make generational wealth last (from rice paddy field to rice paddy field in three generations). To remove the step up basis for immigrants, the poor, and those in the middle class trying to ascend and continue the lineage is a big disincentive.
The step up basis would effectively make it tax free for his kids, though, without some other adjustment. That step up basis means you could sell the next day tax free whereas if the deceased person had sold it 1 day before his death, it would be taxed at up to 24% (20% long term cap gains +3.8% stock surcharge on high incomes) currently.
I personally would get rid of the step-up basis and just make the taxes due upon sale of the item/business in question as regular long term capital gains. This would allow people to continue to own and run the family business or keep the family house(s) but once sold, then you’d have a tax bill of the same amount the deceased would have. Obviously cash and equivalents would be taxed at the time of death.
Any difficulty in passing generational wealth comes from from bad decisions from heirs or because there is so much inequality in the first place incentivizing the extreme wealthy.
This article mostly seems a place of deep ignorance and a bit surprised at the seeming lack of understanding as a long time reader. I would really look into the data behind who uses the stepped up benefit as the bulk of wealth and then form policy proposals based on that. It irks me when people use rare examples that sound terrible and then describe the whole policy as a failure because of those (like a multi-billion defense contract helping a few veteran small businesses when 99% of the contract goes to Boeing or how our farm subsidies are given out with ads of small families on a farm in Iowa).
Your points about excluding less wealthy individuals or perhaps even not requiring immediate taxation without an heir actually selling a property makes sense. Also, I’d note that policy proposals are mostly gutted when the actual legislating happens, which really hasn’t even started in earnest. Most cases, corporatists win out, especially given Manchin’s role in the senate and on the filibuster.
If the topic irks you, I welcome you to write a guest post with some solutions and suggestions.
Do you have children and or run a small business?
Why would we assume they wouldn’t do something of value and who would be the judge? Imagine if you were one of the kids of Thomas Edison, imagine comparing yourself to what he did. Do you think he kids should have been stripped of all their fortune, because their dad was too revolutionary. He changed the entire world, so now they should give up their monies, because they can’t do the same.
This logic of feeling that we have to take from one group to give to another because the first group doesn’t deserve to “win the lottery”. What about all the time the parents in the reference example spent away from their kids, and the sacrifices the family made to become wealthy. Why should the family not benefit from the work and effort of the previous generations?
I still go back to the Ant and the Grasshopper story. Everyone that thinks someone else doesn’t deserve what they have can easily be seen as the grasshopper. Don’t blame the wealthy Ant for doing the work required to be ready for winter.
Hi Sam,
I think you conveniently leave out the parts that they expect to have some threshold for this estate tax and there will very likely be an exception for 90% of family farms. Therefore, the people touched by this stepped-up estate tax impact are likely to be only those who are ‘very’ wealthy – let’s say the top 5% of Americans.
Regarding small businesses, in most cases such businesses are sold as the original owner ages or transferred to offspring to continue to run before death. Given that these people are typically financially savvy, the shock of a surprise tax bill should be limited.
I am not a fan of taxing the wealthy (as I am one) but it is quite clear that those who have benefited most from American democracy and capitalism should be willing to help pay for it and lend a hand to those most in need. Yet, over the last 50 years taxes have significantly decreased as a % of GDP, particularly for the wealthiest. While at the same time, (most may be surprised) govt. spending as a % of GDP has been relatively flat… Therefore, the largest reason our national debt is exploding is primarily due to continuous tax cuts, not oversized spending. It is certainly easy for congressmen to give away tax cuts to grease their reelection chances yet push the consequences of those actions to someone else in the future. It’s a shame we take such a short sighted view of America and our challenge to continue to be the “beacon of democracy” in the world…
“Yet, over the last 50 years taxes have significantly decreased as a % of GDP”
1) We should be getting economies of scale with government as the economy and population grows, so it taxes as a % of GDP SHOULD be going down for everyone
2) This simply is a false statement even ignoring #1; taxes as a % of GDP in total for the US have hovered most years been 15 and 17% of GDP since the end of WW2. It was just over 16% of GDP the last two years and it was 15.7% in 1965 and 15.2% in 1959.
3) Of that which is collected in taxes, the share paid by the wealthy is vastly higher today than in 1965, which is why half of Americans pay zero or negative taxes today and a huge portion pay between $0 and $2,000. The Federal Reserve has a nifty graph showing it all the way back to 1929.
In short, the rich are paying their fair share and then some. The statutory rates on taxes have gone down since 1950, but the # of deductions and loops has gone down even more, meaning taxes paid have increased massively since the 50s/60s.
Well since government spending is PART of GDP the “flat” relationship is a bit of mathematical magic. If more dollars spent increases the numerator and the denominator the overall increase as a percent is lessened.
Not eliminated, but still.
No one likes to pay taxes and you are part of a long list of folks putting out cases against the latest tax plans although you offer no alternative on a fair way to pay for things. Under your examples you could have two 50 year olds where one dies young and leaves money to their kids that gets stepped up so taxes are not collected and the other lives a long life needing to sell assets through retirement while paying capital gains taxes along the way. Why should one family be able to skip taxes while the other pays? Where is the fairness in that? A fairer alternative is maybe to allow for inflation adjustment so the ultimate gain is only above the inflation adjusted value of the initial investment (such would certainly help long term holding small business and farm owners pass down assets) although that certainly gets complicated. The other item everyone is screaming about is potentially doing away with 1031 exchanges. Once again, why should those in real estate get to skip paying capital gains when they sell something versus a business owner or someone selling stock where they reinvest in another business or stock?
No better way to retain the American aristocracy than to retain the step-up in basis! Think of those poor children who will only have $10 million left, which they did nothing to earn, after paying $10 million in taxes…oh, the humanity!
I will start out with the caveat that I agree eliminating the step-up basis is a bad idea.
However, if they are going to eliminate it the middle ground seems it would be to add a timeframe to the required holding after the inheritance. If you inherit your families home and have no intension to sell, you hold it for 5 years and your cost basis resets. On the other hand you inherit a large stock portfolio and decide its time to retire to the beach you pay on the original cost basis for not holding for X amount of time.
Sounds like a reasonable compromise. No capital gains tax immediately upon inheriting and no capital gains after a certain period.
The main issue in America right now is that some people feel like the game is rigged against them (it isn’t). Just because someone else has something of value or is wealthy that means that doesn’t mean you too cannot be successful and build wealth. The overarching desire amongst many younger people is to take wealth away from those who have spent their life working hard to accumulate assets. I don’t see this pursuit stopping any time soon unfortunately.
Exactly!!
The reasoning behind Sam’s article is sound, and I agree with it — as do many others.
Unfortunately, none of that matters.
The government has spent an obscene amount of money over the past few years, and the pace of that spending is only increasing since we have single-party control over the entire government. They want the money, and they’re going to take it. What’s right, fair, properly motivating, or best for the long term health of the economy doesn’t enter into it. They want. your. money. Period. And they have the means to take it. So they will.
If you think loss of the step-up tax basis is bad, wait until they decide they’re going to heavily tax withdrawals of both principal or interest from Roth IRAs and 401ks in retirement. Double taxation, you say? Too bad. I’m sure the Commerce Clause fully supports what ever they decide to mete out to those of us stupid enough to work hard, invest wisely, and save over the course of our lives.
Sam – thanks for all the great articles. I’m wrestling with this / and other new laws that have been recently imposed in California; and I’m sure more coming. My family, over the generations, has been on various side of the have / have not fence. Each time only hard work, saving, and luck pulled us out. Luck which is as you know is many times not equally in America. On one hand I don’t believe dynasties that’s limit children drive to achieve. With a special needs child, I’m desperate to insure for their financial security – the US (the wealthiest nation in the world) is deeply anemic when providing for those with disability. Still – I believe there is a point where one can modestly live for indefinitely. I believe you came to a similar conclusion – 10M or so. So 11M for each child seems to be reasonable to me. After that, let’s be honest – was probably a bit of society helping with ones successes. This is arguably the best place in the world to start a business – mostly for what the Govt provides. Reliable utilities, rule of law and reasonably prompt recourse, relatively lower corruption, notice I didn’t say education. The cynic in me wants to believe in why pay for education here when you can just procure cheaper elsewhere.
After that threshold – or something a better financial person can derive (maybe $50M) spend the money, stimulate the economy, enjoy your earning, hoarding should is the 8th deadly sin.
I agree in large part. Though I don’t necessarily see how it is an undue burden to be taxed on an asset’s original basis at the time the person who inherits the asset eventually sells the asset. I think you gave the example of the farm that just continued to grow in value and so presumably the estate tax threshold would kick in — which could be a big deal considering the difference in Trump’s estate tax limits and Biden’s 3.5M limit. So I won’t take away from that, and I do wish that we just kept the old Trump limits.
That said, I don’t see why it’s business or family-breaking for the 2nd or 3rd generation of an inherited family business to have to make a difficult decision about keeping that business going. If it’s valuable enough and has a reasonable operating revenue, can’t they take out a loan against the value, or find an investor willing to join in the risk and purchase a portion of the asset? If they are smart, they can pay off that investor’s portion of the asset gradually in a way that makes sense for everyone.
It’s because successfully running a business that your parents expertly ran for decades is already hard enough. But then having to borrow money to pay capital gains tax is essentially putting yourself in the hole before you even start.
So mentally, you start thinking to yourself, why bother grinding it out and running this business if I don’t absolutely love it. I might as well just sell it and pay the taxes and have this windfall and end my parents’ legacy.
When it comes to a family business, it’s way more than just the money. The legacy is something that becomes increasingly important as we age. We want to know that some part of our work lives on after we are gone.
Having to figure out more ways to operate profitably and efficiently due to more headwinds is just another reason to not keep a business going.
Perhaps the disconnect is because many people do not run their own business, even though there are about 29 million businesses in America. So from an employee’s perspective, they may be thinking, who cares.
It seems to me that if this went through as currently proposed, private equity firms would end up buying a large amount of small/medium sized businesses at distressed prices. It seems like the government wants to push ownership away from individuals and toward institutions. They should increase the limit to $10 million exclusion for capital gains and keep the estate tax limit close to where it is now. Unless we want PE firms to own even more US businesses. We all know how PE feels about wages, debt and cost cutting.
I think your answer is fair enough and I do think you are right and there are a non-trivial number of businesses that would go under after 1-2 generations.
I just think that if the business is important enough to the family, then they can take out a loan on the estate tax and keep the business going without experiencing a non-commensurate hardship. And if they try for a few years and it fails, they can sell it, then pay capital gains on the increase between the original basis (or an adjusted basis based on claimed losses and other tax-planning magic) and they still inherited a nice chunk of wealth. (In almost all cases)
And you are right, I don’t own a family business or anything (though I am a part-owner of a business with about 60 other people and have pretty massive overhead contributions, so I’m definitely not an employee). So I do not discount your opinion on this. And heck, I’m not even in favor of losing the step up basis or lowering the estate tax limits. Maybe I’m just trying to make peace with the direction that tax law is going and this is my coping mechanism.
Man, I generally liked the tax rates/codes as-is. Now it seems like so much change is going to happen. Although it seems the government is doing a lot of things to raise taxes and lower the income inequality gap, I can’t believe that they would increase the taxes so dramatically and quickly.
Tax risk is so real. Have to time sales not just accounting for when you make or lose money but based on tax rate changes as well.
It is undisputed, that inequality is a massive and growing problem in the united states.
I personally think that eliminating step up basis is an excellent idea.
Any kid getting a large inheritance is in a wonderful position.
Are you really arguing here that he should get 10Million in a farm instead of 5 million? That this kid is the kid who is being victimized?
America should give every kid a chance. A large inheritance tax is a very good idea. It also spurs on investment and spending as you know that if you die…a good chunk of it goes to the government. And everybody dies…….
Contrary to what you might think, running a farm or any business takes an incredible amount of work, deliberation, execution and stress.
A day job is much easier compared to running a business. Such businesses will decline in formation or increasingly be sold. Are you a small business owner?
Simple.
A) A step up is permitted because the estate currently bears the tax (the deceased’s assets are recorded at FMV, the exemption applied and tax computed. Since the assets were taxed at FMV upon transfer to the heirs they are stepped up to the current FMV.
B) If they are like the O.1% in America, they hire someone like me – a Big 4 tax advisor – well in advance of death to properly structure an exit for heirs that is tax optimized. At hourly tax planning rates ranging from $200 (newbies) to $1800 (seasoned professional) small business owners are generally the ones who find out there is an issue after the death has occurred.
I include in “small business owners” people like my grandmother who had three rental houses upon her death (her fathers house, a sons house who has preceded her in death and her own home she had lived in before moving in with me.
If the step up is eliminated then the estate tax exemption no longer makes sense for most Americans and the rich (who have more cash which has
a basis which has equal to fair market value) benefit more than the average Joe. For example assume the estate tax exemption is 11M.
Richie Rich has 5M in cash and a property w FMV of 8M and basis of 6M He did no tax planning. He uses his entire estate tax exemption and because there is no step up would owe tax on 2M excess transfer. The crowd cheers.
Average Annie has $200,000 in cash, house worth $825,000 with a basis of $25,000 and a small alterations shop worth $3,100,000 with a basis of $100,000 (consisting of a fully depreciated building located on a busy street corner she bought 40 years ago). Annie would use only 200k + 25k + 100k = 325k of her estate tax exemption despite having a total estate valued at 4.125M. She/her heirs would
pay tax on 800k + 3M = 3.8M. What? The rich win again?
I think the equitable solution is to allow step up and have the estate tax limit (currently 11M) fluctuated to reflect current ideas about appropriate weath transfer.
Thanks. I’m not sure if you were responding to me as I didn’t ask a question about examples, but I’m glad you did.
Your Average Annie example is who we should try to protect. Especially if the heirs must pay a capital gains tax immediately upon receipt.
Who has $1.2 million lying around to pay the CGT? Not many, which is why the business would need to be sold or one would have to borrow to pay for the CGT.
And if the CGT is only paid upon sale, the business might be an albatross on the inheritors neck as she begrudgingly tries to keep the business going, which likely results in a business decline.
Removing the step up is a huge disincentive to keep small businesses going.
I don’t understand this logic. The dollar value isn’t really the issue by the way it’s the lack of step up that causes the problem for any asset and value. Losing $40k to taxes would hurt just as much it doesn’t always have to be about all these millionaires out there. The tax code is uniform. Why should the farm kid not be able to keep what he was given. And, by your potential logic path, why does he has to lose assets for another kid to have a chance? Aren’t these mutually exclusive ideas.
How much of your salary post taxes are you giving away so other kids can have a chance? I assume you are donating well over 50% post taxes by the above statement.
Come on, why are you hording for your family, other’s need a chance too… You already had yours.
I’ll start by saying I don’t have an issue with the step up in basis. Your kids have the benefit of your education contacts and training. They should be able to make it without your largess as should mine…
But. I have one major concern which probably relates to why this exists in the first place. The reality is the expiring owners basis is not always known for all assets. Depending on how far the law ventures from asset like stocks things could get fairly complicated quickly for an estate. Imagine it has an expensive piece of art, antique car, or even a home bought decades ago. What are the odds the original owner long ago lost their purchase price info or maintenance records, especially if towards the end of life their faculties are compromised. Could make things a complicated nightmare if done wrong.
Blockchain can solve this. It would be straight forward to create a source of truth that would be tamper proof to be preserved into posterity. Probably a good business idea.
Maybe for future items. But it doesn’t solve for something your dad bought in the 1970s. The block chain can’t provide that which doesn’t exist.
It’s a big problem for the privileged and a small problem for society. We already know most family business are not multi-generational. 30% make it 2 generations, and only 13% make it 3 generations. And of course many small businesses are professionals (lawyers, doctors etc.) which if your children are not lawyers or doctors they won’t be continuing on. And of course, all of this could be mitigated by selling shares of your company to your child while you’re alive eliminating any inheritance of a business/farm/etc.
The reality is wealth inequality has skyrocketed in the United States. It’s been well documented that the return on capital is higher than the rise in wages. Therefore, if as a society we decide we don’t want wealth to be ever more concentrated, we need to do things to prevent that. And with asset price inflation, perhaps forcing the sale of inherited assets will drive down asset prices bring us to a more acceptable equilibrium.
I agree, we shouldn’t encourage families to build wealth for the next generation. Every time a parent dies, Wealth should be reset to zero and their children should start from scratch to make things fair.
Immigrants are coming to this country and starting small businesses. We shouldn’t allow them to help their kids prosper for the next generation.
All wealth should be reset to zero every generation!
Those are your values. Some people might believe you should not build any wealth in your lifetime and would tax you more now because they think you have “enough.”
Not sure why you’re singling out immigrants. Many parents want to help their children out. The reason why US is dominant on the world stage is because of growth and economic might, much of which is driven by hungry entrepreneurs (immigrant or otherwise) taking risks and starting new businesses and innovating.
The focus should not be on making it a perfect level playing field because it never will be because of individual ability, connections, race, etc. but removing barriers to entry for success.
Who gets to define “privileged?” and what is or isn’t a problem for society? It’s all relative. A low-8 figure net worth (current Estate tax threshold) is quite attainable and typical for an upper-middle class family on the coasts who work hard enough and invest.
Wealth inequality has skyrocketed but this in part due to structural changes in the economy from agrarian/manufacturing to an information-based, service one, which will benefit some to the exclusion of others. Everyone is literally pushed into investing (whether stock market or real estate, etc) just to keep a middle/upper-middle class lifestyle which is why retail investors are an ever growing share of the total market. Yet something like 50% of Americans don’t own any stock.
Drive down asset prices? Equilibrium? We don’t operate in a vacuum. If the financials work, corporations or foreign investors across the globe will just pick up the assets, not your middle/lower-middle income families who have no savings or money to invest. Just look at the arbitrage of CA and NY folks buying up everything in the heartland since it’s “so cheap.” Life isn’t fair. I don’t have any solutions, but I’d love to hear what you think will help these folks.
In Australia we don’t have the stepped up basis, but you don’t need to pay CGT unless you sell what you inherited. This makes sense. I haven’t seen in articles I’ve seen on this that the US proposal requires paying the tax either unless the asset is sold. BTW, there are no inheritance taxes in Australia.
Great to hear you guys don’t have any inheritance tax in Australia.
I wonder what happens to business operations if heirs don’t want the business, yet don’t want to pay the capital gains tax either.
This makes total sense to me as the solution to this debate. Only tax the inherited capital upon sale. The idea of a stepped up basis seems privileged. Why should someone who inherits an asset get to skip the capital gains tax altogether if they sell it immediately upon inheriting it? Why should that particular gain in capital from the initial purchase of the asset be exempt from tax just because the original owner died? It doesn’t make sense to me.
IMO the solution is to definitely remove the stepped up basis and only tax the inherited capital upon sale. This removes most of Sam’s concerns and also allows the capital gains to be preserved on record and taxed upon sale if there ever is a sale.
I don’t agree Sam, but I don’t disagree either.
I think the compromise would be like the estate tax, put a reasonable limit on it where anything above does not enjoy the step up.
The middle and lower class should be able to build generational wealth. Those who are more fortunate should pay back more into the system.
Now what the limit should be, I don’t know. It’s tough to gauge.
Those who are more fortunate already pay virtually all of the taxes.
The thing that is always baffling to me is that politicians from both parties never make proposals that are surgical in nature. Everything is always a hammer.
For example, when Republicans and Trump lowered the corporate tax rate, they dropped it all the way from 35% down to 21%. In 2017 when they did this, business and the economy was doing pretty well. If they wanted to light a fire to keep the economy going up, why not simply lower it to 28% to provide a little bump?
We can at least give Biden a little credit in that he doesn’t want to completely undo the corporate tax drop; he wants to compromise and put it up to 28%, halfway between where it was and where it is now.
What he wants to do with capital gains tax and step up is back to hammer thinking, though. I wonder if this is all political theater where he hits everyone with the hammer, everyone balks, then he comes in and compromises to something more reasonable and he gets to keep his self applied mantle of a grand compromiser.
Compromises will have to be made. There’s no way the CGT goes to 43.4%. Maybe 30%.
I don’t see the complete removal of the stepped-up basis either.
Lowering the estate tax threshold after years of inflation and capital growth is going to be tricky too.
You situation with your kids’ future play and your website sale is funny. Like you said on the one hand they could sell the site and pay half the taxes and get $10M for doing nothing. Hopefully, they read your site though, and think about the long play and the revenue generating asset they would have if they kept it going. That exact situation is why people I think are split on saving for the next generation or saving/spending for themselves. Everyone thinks they can make life better for the next generation but you have no idea how it will play out. People make all kinds of crazy life style choices even with the “right” schooling, background, etc.
Imagine that though, your kids just sell and buy a car that’s not 1/10. They just cash out and get the lambo. Somehow, I doubt that will be the case though.
BTW looking forward to reading your site for another couple decades.
Might not happen actually. If the total capital gains tax rate goes to ~56% in California and there is no stepped-up basis, I’d probably sell before the tax is implemented or just let things fade.
Just too tired to keep going. This post took hours to write and edit. Even when I thought it was ready today, I worked on it from 6:15am – 10am this morning, missing playing with my kids in the process. That stinks because I’m certainly not going to be rewarded for writing this post.
But all these tax changes and signals are a catalyst for me to take it down a notch and follow my pre-retirement check list. I really enjoyed my retirement life from 2012-2017. Then taxes got reduced starting in 2018.
It’s time to enjoy the YOLO economy to the maximum!
This is either fear mongering bc you’re afraid you’re not going to pass through your wealth to your kids…or…you’re misinformed…or both.
LOVE it when wealthy people try to hid behind “small business” and famers” as a means of protecting their wealth…come on Sam, you’re blog is normally great but this is such obvious smoke an mirrors here. For starters, the step up basis being discussed addresses these specific issues. What is being discussed is carve outs for family owned businesses and deferrals of payments until the business is sold and/or long term payment plans (15 years).
There is no rational justification for the step up basis, zero. This is coming from someone that is going to benefit from it immensely. There is really no rational reason to have this. Deferrals until an asset is sold vs paid immediately is the only thing that really makes sense (and are what is being discussed anyway, at least for some assets).
That said, adding some form of inflation adjustment to the cost basis – just make it a fixed percent based on long term average to keep it simple – would be a very reasonable thing.
I agree!
I don’t think minorities or first generation immigrants should start small businesses to try to get ahead in America. Removing the stepped-up basis should disincentivize these immigrants from starting business we true-blooded Americans should have started!
Passing down a valuable business that took decades to run should be taxed up the wazoo! It is not fair that the kids of immigrants who did not work as hard for the business get to inherit such a huge fortune without having to pay more taxes. America gave them the opportunity!
There are so many wealthy immigrants who are coming to our country already. We should tax them for starting businesses and maybe even tax them more for taking our jobs and resources.
‘Merica!
Your attitude is so disappointing. Why are you trying to turn this into an immigration issue? Someone who blames immigrants for American not starting businesses is what a lazy, uncultured person would say.
Totally agree with Jamie , Billy sounds too bitter . We as immigrants worked so hard it’s not easy to stay away from family and work , raise a family and a business .
Sheesh. With that type of attitude you must not have achieved much in your life that you could pass down or don’t have any kids. What have you created on your own?
The step up basis is at least partly because there are so many things a person might inherit where it is obvious there is no way to ever determine what the basis might have been, or should have been. Every estate would drag the IRS into many years of button counting. Where did that nice antique brass clock on Grandma’s mantle come from? When might she have purchased it? How much is it really worth today? How about that gold pocket watch that great great great grandpa wore when he was in the War of 1812? Or that scrimshaw belt buckle? Then multiply this process by hundreds or thousands of items per estate.