When you sell a capital asset like a share of stock, you pay tax on the profit. If you bought the stock at $1,000 and you sell it at $1,500, you have a "capital gain" of $500. In tax lingo, $1,000 is called your "basis." If you got the stock as a gift, your basis is whatever your donor paid for it. All pretty reasonable.
But what happens if you inherited the stock? Here the tax code contains a bizarre loophole. Your basis is the value when you inherited it. If your benefactor bought the stock for $1,000, died when it was worth $1,450, and you sold it for $1,500, your capital gain is only $50. As my estate planning professor in law school explained with delight, "The angel of death comes along and 'steps up' the basis." A capital gain of $450 escapes tax forever.
This is no small matter. The Congressional Budget Office estimates that taxing capital gains when property is transferred at death would bring in about $5 billion a year. Five billion dollars is more than a quarter of the $19 billion in new revenue the Democratic-controlled Congress is committed to finding for next year's budget. (In response to this responsible commitment, our hypocritical Republican president, whose own budget is a delirious fantasy of accounting flim-flam, denounced Congress for "caving in to its old tax-and-spend addiction.")
Closing the loophole for inherited capital gains is one item on a Ways and Means Committee shopping list of possible revenue measures. There is no fairer or more efficient way to bring in five billion smackers.
Although this loophole has no rational justification, it is deeply treasured by its beneficiaries. So be prepared for flights of demagoguery and obfuscation in its defense. The main defenders will be lobbyists for "small" business and "family" farmers, two of the great political euphemisms of our day. Small businesses are not generally owned by small people. The typical small businessman is a lot wealthier than the typical shareholder of IBM.
The National Federation of Independent Businessmen, the small-business lobby, complains of "the inherent unfairness of taxing someone for dying." This misses the point. The issue is not some new death duty or estate tax. The issue is whether inherited property should escape entirely from the ordinary income tax that most people pay on their wages and savings.
There's no denying that closing this loophole would affect some middle-class people as well as the rich -- especially those who have enjoyed spectacular run-ups in the value of their houses. But there is already a $125,000 lifetime exemption for any profit you make on your own house. Why shouldn't the lucky heirs of people who make more than this pay a bit of tax like everybody else?
Defenders of this loophole will make much of the terrible burden of paper work that will be required of heirs who will have to figure out what their parents paid for this or that bit of property. Aw, poor babies. You can be sure that if the same paper work were required to take advantage of some loophole, the burden would be shouldered without complaint. The people who would be hit hardest by this reform, and will lobby hardest against it, are financial sophisticates with no lack of business records.
It will be noted that the capital gains tax hits "phantom" profits that only reflect inflation. That's true. But it's also true of the tax on savings-account interest. Unlike interest, capital gains are allowed to accrue and compound tax-free until they are cashed in. Whether this advantage outweighs the disadvantage depends on the rate of inflation and the size of the profit. In any event, there is no reason that only inherited property should get special treatment to account for inflation.
Finally, of course, there will be the usual blather about this "tax increase" destroying the incentive to produce and create. Any type of income tax does reduce the work incentive to some extent. But it's hard to think of a tax for which this is less of a problem than one that doesn't apply until you die. And, once again, given that we must have taxes, why should this particular category of income enjoy a tax rate of zero?
Besides the fairness issue and the need for revenue, there is an important economic efficiency -- dare I say it, a "supply-side" -- argument in favor of closing the loophole for inherited capital gains. Knowing that their profits will escape tax completely if they don't sell before they die leads people to hold on to investments they might otherwise liquidate. This phenomenon -- called the "lock-in effect" -- distorts the economy and also reduces government revenues by discouraging taxable transactions.
Although a mere $5 billion is at stake, the fate of the Ways and Means proposal to tax capital gains at death is a test of political integrity. Fiscal responsibility, fairness, and economic efficiency all dictate that this loophole be closed. Anyone who opposes this reform clearly has some other agenda.