Take-Away: Regardless who wins as the next US President, there is a strong likelihood that the rule that provides an income tax basis step-up on the owner’s death will be subject to change.

Background: What do Joe Biden and Donald Trump have in common, besides both wanting to be elected President in 2020? They both think that the existing rule that provides an automatic income tax basis adjustment on the asset owner’s death should be eliminated.

IRC 1014: The existing Tax Code permits the person who inherits the asset to have a fresh income tax basis in the inherited asset equal to that asset’s fair market value as of the date of the previous owner’s death. This is often referred to as a step-up in tax basis (although it is also possible that the income tax basis of an inherited asset could go down, lower than its cost basis, but we never seem to want to talk about that possibility.) [IRC 1014.]

Free-Basing: This basis adjustment-on-death has attracted considerable attention over the past few years, especially with the dramatic increase in the federal estate tax applicable exemption amount and portability, which makes federal estate taxation a remote concern to most Americans. Rather, the attention has turned to saving income taxes, and one way to do so is to hold assets until the owner’s death, to expose the decedent’s assets to an income tax basis adjustment under IRC 1014. It has also manifested itself in intentionally causing the value of trust assets to be included in the trust beneficiary’s taxable estate to gain a fresh income tax basis in the hands of the remainder beneficiaries, e.g. giving the lifetime trust beneficiary a testamentary general power of appointment over the trust assets. This fresh start income tax basis for inherited assets can save substantial income taxes.

Example: Bill and Hillary paid $5.0 million for a commercial building 28 years ago which spun off considerable rental income. During those 28 years Bill and Hillary took depreciation deductions of $4.5 million. The commercial building is now worth $20.0 million. Bill and Hillary die this year in an auto accident. Had Bill and Hillary sold the building just prior to their deaths, they would have owed federal income taxes at the 28.8% rate (25% + 3.8% net investment income tax (NIIT)) on the $4.5 million gain, as a recapture of their previous income tax depreciation deductions, and long-term capital gains taxes at a 23.8% rate (20% + 3.8% NIIT) on the $15 million of appreciation over the 28 years. Bill and Hillary would also pay substantial state income taxes since they are residents of New York. But Bill and Hillary did not sell the building before their unexpected deaths, so their daughter, Chelsea, inherits the commercial building. Under existing IRC 1014 Chelsea takes a new income tax basis in the building of $20.0 million, which was the building’s fair market value on Bill and Hillary’s deaths. Accordingly, Chelsea can re-depreciate the building using its new $20 million income tax basis which can offset some of the taxes on much of the rental income that Chelsea can expect to receive from the inherited building over the coming years. Chelsea could also sell the inherited building for $20 million and not pay any capital gains taxes. If Bill and Hillary’s combined estates are worth less than $23.16 million (ha!) there would also be no federal estate tax for Chelsea to be concerned about either.

Three Possible Scenarios: Assuming that there may be a change in the near future in the income tax basis step-up rule, that change might take three possible forms.

  1. Carry-Over Basis: The elimination of the step-up in income tax basis without an immediate tax due at death; in other words, carry-over basis. Carry-over basis could appear while maintaining the current federal gift, estate, and GST tax system. This would be like the existing gift-tax regime, where the donee takes the donor’s income tax basis in the gifted asset, i.e. carryover basis , but the capital gains tax would only be paid when the donee or estate beneficiary decides to sell the gifted/inherited asset.
  2. Replacement Tax: The elimination of the step-up in income tax basis with an immediate capital gain tax paid by the decedent’s estate on the unrealized appreciation at the time of the asset owner’s death. The immediate capital gain tax paid would be a replacement for the current federal estate and GST tax system. This approach adopts the deemed disposition tax regime on death, comparable to what is currently used in Canada. [More on Canada below.]
  3. An Additional Tax at Death: The elimination of the step-up in income tax basis with an immediate capital gain tax on the unrealized appreciation at the time of death paid by the decedent’s estate. The current gift, estate, and GST tax system would be maintained, although possibly with lower estate tax rates in recognition that there will also be a capital gain tax paid shortly after the owner’s death. This approach has not gained much support by  advocates of tax reform (or simplification.)

Canada’s Deemed Disposition Tax: Spending a bit of time looking to our neighbor to the north, we might get a glimpse of what might be in our future. Almost 50 years ago, back in 1972, Canada replaced its federal estate and gift tax with a capital gains tax directly tied to an income tax regime. Canada’s Income Tax Act provides a deemed disposition of capital assets at the time of a gift or at the owner’s death. The donor, or decedent, is considered to have disposed of all of his/her capital property immediately before the gift or at death, and to have received the ‘deemed proceeds.’ If the proceeds are greater (or less than) the decedent’s cost basis, an income tax is assessed on the capital gain (or loss.) If gain is recognized, the tax is paid by the donor, or the decedent’s estate as the case may be, before the property passes to the recipient.

  • Fresh Start Basis: Before Canada’s deemed disposition tax was effective in 1972, all capital assets had their cost basis adjusted to their fair market value as of December 31, 1971. This fresh start eliminated the mad scramble in a search for purchase records going back several decades. Probably most of the hand-wringing over this change in taxation was eliminated by the ability to establish a new (albeit artificial) income tax basis for all assets using a single snapshot date to set the new tax basis for all assets.
  • Tax Rate: Capital gains incurred in a year are taxed the same rate as the owner’s ordinary income for the year, i.e. there is no separate capital gain tax rate. However, only 50% of the taxpayer’s total capital gains recognized in a calendar year are subject to the deemed disposition capital gain The current federal Canadian tax rate for ordinary income ranges from 15% (income less than $45,000) to 33% (income greater than $214,000.)

Observation: Canadian provinces and territories also impose their own income taxes most of which are much higher than state income tax rates (ignoring our obvious exceptions of New York, California, Connecticut, and New Jersey.) Where Michigan’s income tax rate is 4.25%, Ontario imposes an income tax rate of 13.16% on income in excess of $220,000.

  • Exemptions: Some property transfers are exempt from Canada’s deemed disposition Exemptions are available for a principal residence and charitable donations of publically traded stock. Partial exemptions apply for qualifying farm property, fishing, and small business interests and property.
  • Marital Deduction: The capital gains on property that is transferred to a spouse or a common law partner is deferred until the second death, much like the United States’ unlimited federal gift and estate tax marital deduction.
  • Trusts: Because of Canada’s deemed dispositions capital gains tax, trusts are not particularly popular in Canada for three basic reasons. (i)There is a deemed disposition and related capital gains when a revocable grantor trust is funded. (ii) There is a deemed disposition and related capital gains tax on all assets held in an continuing trust every 21 years, which prevents the ability to extend deferral of gain recognition. [This every 21-year deemed distribution tax can be mitigated by the distribution of trust assets in-kind prior to the 21-year deadline; the carry-over income tax basis passes to the trust’s beneficiaries, who, as individuals, are able to further defer the capital gains tax.] (iii) Much like the United States, the income generated by a Canadian trust is taxed at the highest marginal federal income tax rate, but starting with the first dollar earned (while in the US, the irrevocable trust reaches the highest marginal federal  income tax rate of 37% at $10,950.)

Perceived Benefits with a Deemed Distribution Tax System: If, for example, the United States followed Canada’s lead (it just took us about 50 years to get there) and the federal estate tax was replaced with a deemed distributions tax, there could be some interesting results.

  1. Lower Rates: The deemed distribution capital gains tax rate might be much lower than the current 40% federal gift or estate tax rate. As noted, Canada does not tax 50% of the reported deemed disposition gain, although it is taxed at the ordinary income tax rate. Maybe the federal estate tax rate of 40% could be cut by 50% to a flat deemed distribution capital gain tax rate of 20%.
  2. Only Gain is Taxed: The current federal estate tax is imposed on the full fair market value of assets above the decedent’s available exemption amount. A deemed distribution capital gain tax would only be imposed on the previously untaxed appreciation of the decedent’s assets. In short, the tax would be imposed on a smaller amount.
  3. Not a Double Tax:  Many arguments against the existing federal estate tax is that it is ‘unfair’ since it taxes previously taxed income that has been saved and accumulated. A deemed distributions capital gains tax avoids this stigma, as it only applies to previously untaxed, unrecognized, gains.
  4. Encourages Capital Investment: It is claimed by some commentators that a deemed distribution capital gains tax will discourage wealthy individuals from holding their appreciated assets (often in large concentrated blocs) until their deaths, in order to gain the income tax basis step-up for their heirs. Without a basis step up incentive, these wealthy individuals might decide to sell their appreciated assets, recognize their gains, and reinvest the net sales proceeds in diversified investments thus benefiting the entire economy.
  5. Basis Consistency Promoted: The IRS has spent a lot of time, energy, and paper in recent years attempting to assure some level of basis consistency when assets are inherited. The deemed distribution capital gain tax would thus harmonize the gift and estate tax regimes, in each case with the recipient starting out with a new income tax basis along with the records to substantiate that basis in future gift and sale transactions.

Conclusion:  Apparently none of Mr. Biden, President Trump,[ and President Obama, too] like the existing step-up in income tax basis rule of IRC 1014. The deemed distribution capital gains tax seems to have worked reasonably well in Canada for the past half-century, so perhaps our country will look to the north when it searches for a more equitable form of taxation. No doubt there are many complications with a major over-haul of the country’s tax system, and the deemed disposition capital gains tax has its own flaws, but it sounds like the step-up in income tax basis rule may be nearing its end.