President Biden told a grim fable to push his proposed end to a longstanding tax exemption for appreciated investments passed on to heirs.
Under current law, when someone inherits an asset—like stock, a business, or real estate—that increased in value during the life of the person who owned it, the asset’s tax basis is increased to the fair market value at the date of death. This increased—or “stepped up”— basis means that the person who inherits the asset will only owe capital gains taxes on the gains that accrue after it was passed on to them. All the pre-death increase in value escapes the net of capital gains taxes—although they may be subject to inheritance taxes.
This means that if the heir were to sell immediately, no capital tax would be owed at all. And if they sell later, their capital gains tax bill will be much lower than it would have been without the step-up exemption. But on sizable estates, the heir would owe the estate tax based on the fair market value. In fact, one of the reasons for the exemption was to prevent heirs from being taxed by both the capital gains tax and the inheritance tax.
The exemption is an obstacle to Biden’s plans to dramatically raise the capital gains rate. Biden would hike the rate from 20 percent for the wealthiest taxpayers to 39.6 percent. When coupled with state-level taxes and a federal investment income tax, the effective capital gains rate for top earners would exceed 50 percent in high tax states like California and New York.
That would likely result in far more people holding on to their gains and passing them on to their children rather than paying over half to the government. That’s an incentive to save and invest, both generally considered positive things. And it would mean that the capital gains tax hike would collect far less than it would if not for the exemption. So Biden seeks to tear down the step-up tax break so people have less incentive to pass their savings on to the next generation and would be encouraged to realize their gains while alive, thereby increasing federal revenue.
In short, repealing the step-up exemption would lower the incentive not to realize gains while alive—by discouraging people from passing on investments to their children and grandchildren—and increase federal revenues from capital gains taxes.
Biden pushed for his plan in a speech Monday with a very weird story about a car crash fatality that results in orphans getting an untaxed gain:
“For example, if I had a million dollars. And stock that I bought made a million dollars and I was going to cash it in, I’d have to pay capital gain on that million dollars. But if—God forbid, in way—go back to where I was, on the way to where I was. On the way to where we’re talking about. On the way to cash in my stock, I got hit by a car and got killed, I can leave it to my daughter and she pays no tax. A tax that was owed two seconds earlier. It’s not an inheritance tax. It’s a tax that was owed two seconds earlier.”
Let’s set aside the idea that anyone is ever traveling somewhere to “cash in” his or her stock. Perhaps in Biden’s social circle, it is common to head down to ye olde stock shoppe to hand over your stocks in exchange for money.
Why on earth would Biden decide to use this horrible tale of a family tragedy to argue for his point? It seems like the least sympathetic case for ending the step-up imaginable. In fact, this tale inspired me to call it the “grim reaper tax.”
It’s also true that Biden is not technically correct. The tax was not owed two seconds ago. In Biden’s story, it never comes due because the gain is never realized. The step-up doesn’t erase a realized gain, it merely erases unrealized gains.
This is important because even if the step-up exemption is repealed, it may have less of an effect on the behavior of asset owners than is thought—and therefore raise less revenue than expected. Even after the step-up is eliminated, the increase in value is never taxed until the asset is sold. So an appreciated investment can continue to avoid taxes from one generation to the next—so long as it is not sold. Heirs that expect or hope the step-up could be reinstated would be discouraged from selling until the law is changed again.
As a result, the Biden reform might result in more intergenerational wealth accumulation than the current system. That’s especially true for the very wealthy, who are less likely to be forced to sell appreciated assets to pay for things like a child’s education or other family expenses.
And what about the non-ultra wealthy? One thing to notice about eliminating the step-up is that it would not just tax the ultra-wealthy. A guy who started a business a few decades back with a small upfront capital investment or someone who bought a few stocks that went up over decades may now be sitting on a sizable appreciated asset in what is still essentially a family business. Biden’s reform would mean that his children would face a huge tax bill if they ever decided to cash in dad’s investment in order to, say, pay for their own child’s college education. Whether or not dad died of natural causes or in Biden’s imagined car crash, it still seems unfair.