Watch Your Step!

Cost Basis Step-Up, a Quick History and Why it is Still in the News

You may recall there was a lot of discussion around tax reform in 2021, with quite a bit of attention given to the threat to repeal the step-up in cost basis upon the death of the asset’s owner. While that change in the tax law did not come to fruition in 2021, the deliberation on the merits of a basis step-up is not going to go away anytime soon.

The step-up in basis rule came into effect in 1921, a mere five years after the federal estate tax became law in 1916. The step-up in basis rule states that when an heir inherits an asset, of any sort, the cost basis for taxation purposes will be the asset’s fair market value on the date of the owner’s death.

Alternate valuation date: One exception to this rule is that the personal representative or executor of a decedent’s estate can opt to apply an alternate valuation for inherited assets based upon the asset’s fair market value six months after the decedent’s death. However, all assets owned by the decedent will be subject to the alternate valuation date, meaning that the executor cannot ‘cherry pick’ which assets receive the alternate date fair market value. It should be noted there is a condition to using the alternate valuation date; the use of a ‘snapshot’ valuation date six months after death must reduce the estate’s tax liability.

One-year transfer rule: A second exception to this step-up rule is that no step-up in basis will be allowed if the asset in question was acquired by the decedent (i) from the designated heir (ii) during the year prior to the decedent’s death. This prohibition of the step-up rule is intended to deter tax-motivated death bed transfers simply to gain a basis step-up on the recipient’s death.

The federal Joint Committee on Taxation projects that because of the application of the step-up in basis rule almost $42 billion was lost in federal revenue in 2021. The original reasons for the step-up in basis rule are not exactly clear. The main rationale seems to lie with the federal estate tax. The federal estate tax is levied on the transfer of the fair market value of all assets owned by the decedent at the date of his or her death. Therefore, the taxable base of the assets involved with the federal estate tax is their entire worth, not just the amount of appreciation that has accrued since the asset was acquired by the decedent.

In 1921, Congress was apparently concerned about imposing an income tax on an inherited asset’s unrealized appreciation after the same asset was just subjected to the federal estate tax at its fair market value. Thus, to avoid excessive taxation of the same asset, or essentially double taxation, Congress provided that such an asset would have a basis for income taxation purposes in the hands of the heir equal to the asset’s value that was used to determine the estate’s federal estate tax liability, i.e., the asset’s fair market value.

1976: In the Tax Reform Act of 1976, Congress repealed the step-up in basis rule, imposing in its place a carryover basis rule like that used for lifetime gifts. This legislative change was immediately challenged primarily due to the record-keeping problems associated with reconstructing what a long-deceased relative might have paid for assets that had been held for generations. As a result of this opposition, Congress initially delayed the effective date of the carryover basis rule. Ultimately Congress repealed the carryover basis rule in 1980.

2010: Carryover basis was in effect for only 2010, when the federal estate tax was also repealed for that year. IThis law dates back to 2001 in George W. Bush’s first term. The change in law indirectly acknowledged that without the federal estate tax, the purported rationale of the step-up in basis rule was effectively nullified and, therefore, the step-up rule had to be repealed. In its place, still another variation of the carryover basis was enacted for inherited assets, but a significant remnant of the step-up in basis rule was retained: $1.3 million of appreciation was allowed to be stepped-up on a decedent’s death, plus an additional $3.0 million for assets transferred by a decedent to his or her surviving spouse. These allowances recognized that while repealing the federal estate tax in exchange for no step-up in basis rule appealed to taxpayers with considerable wealth that exposed them to federal estate taxes, the vast majority of beneficiaries that inherit property would receive a step-up in basis without having any exposure to federal estate tax.

Clinton proposal: President Clinton proposed during his presidential campaign an alteration of the step-up in basis rule, but the proposal never made it out of the House Committee.

Obama proposal: President Obama also proposed a repeal of the step-up in basis rule, but since it was made prior to an election year, nothing happened to that proposal.

Biden proposal: President Biden’s revenue proposals for fiscal 2022 sought to repeal most of the basis step-up rule without a quid pro quo to eliminate the federal estate tax. This proposal was part of ‘package’ of several revenue proposals in an attempt to equalize the taxation of what the President called ‘work’ and ‘wealth.’ Hence, Biden proposed to tax long-term capital gains as ordinary income for those individuals with an income of $1.0 million or more. However, in order to prevent wealthy taxpayers from easily avoiding this new income tax rule on their long-term capital gains by simply holding onto their appreciated assets until death and gain the benefit of a basis step-up, President Biden’s proposal removed this disincentive to realize capital gains during the owners’ lifetime with a repeal of the basis step-up rule. This proposal did provide a $1.0 million basis step-up per individual like the current law (adjusted for inflation after 2022, and portable between spouses) recognizing that an income tax due on the death of the asset owner would cause a hardship on non-wealthy Americans. As we now know, this proposal did not go anywhere during last year.

Some observations on the possible future repeal or modification of the basis step-up rule follow:

Double taxation rationale disappears: No matter how any of these prior proposals are viewed, the rationale for the step-up in income tax basis rule has always been to avoid double taxation. The rationale of this line of thought is questionable if no federal estate tax is actually paid by the originating decedent’s estate. With a federal estate tax exemption per person now exceeding $12 million in 2022, there is no duplicate second layer of taxation on a decedent’s assets for 99% of Americans, so there is no reason for the inherited property’s basis to be stepped-up to its fair market value when the decedent passes away. According to the Tax Policy Center, with the currently high federal estate tax exemption, less than one out of a thousand decedents will likely owe any federal estate tax. Another way to look at it, a step-up in basis in an inherited asset is not contingent on that asset actually being subject to the federal estate tax due to the likelihood that no federal estate tax will ever be paid. As a result, the appreciation in value of inherited assets, for most heirs, will escape both income and estate taxation. Therefore, the double taxation reason for the step-up in basis rule applies only to a very small minority of situations when appreciated property is transferred at a wealthy owner’s death.

Increase in retirement account Saving: It is important to also acknowledge that an increasing number of individuals in this country have the bulk of their financial assets held in retirement accounts, for which there is no income tax basis. With a change in the step-up in basis rule, these retirement account assets might be placed on a more equal footing with a taxable investment portfolio, which has its entire appreciation exempted from income taxation due to the current step-up in basis rule. With a change in the basis step-up rule there might be more incentive to invest in retirement accounts than in after-tax investments when any gain would be recognized on the owner’s death. Whether that is a good thing or a bad outcome is debatable.

Lifetime gifts increased: Rather than sitting on appreciated assets until death to gain the basis step-up, asset owners might be inclined to make lifetime gifts of those appreciated assets to their heirs if there is no benefit to be gained for holding the appreciated assets until their death.

An administrative nightmare for fiduciaries: Assuming some proposal close to what President Biden submitted with regard to a limited repeal of the step-up rule comes to pass, e.g. $1.0 million of tax-free appreciation is available on the owner’s death, that new rule would require fiduciaries of estates with appreciated assets that exceed the threshold dollar amount to determine which appreciated assets would go to which beneficiary and whether to consider the individual beneficiary’s individual tax circumstances. While some fiduciaries might simply ignore the limited step-up basis opportunity, other fiduciaries might try to minimize the tax liability of the recipient beneficiaries as a whole. Some estates may consist of highly illiquid assets, yet a constructive disposition of assets at-death could create a ‘fire-sale’ situation where estate assets have to be immediately liquidated simply to pay the resulting capital gain tax. An alternative concern for the estate fiduciary is that there are few records available to the fiduciary to calculate the amount of the unrealized gain, or loss, the decedent’s estate may have to declare.

The income tax basis step-up rule has been around for a century. The public policy rationale for this rule, to avoid double taxation, does not apply to most Americans today when their applicable federal estate tax exemption amount now exceeds $12 million, with that exemption amount portable to a surviving spouse. I suspect that it will continue to be difficult for Congress, always in search of revenue, to ignore a rule that leaves $42 billion in potential tax revenue on the table each year. Then again, we are talking about politics which at times can seemingly defy logic. Rest assured we’re keeping a close eye on this and any potential tax legislation that may impact our clients. We will be sure to keep you well informed.