A significant loophole in the U.S. tax code allows wealthy individuals to avoid paying capital gains taxes on their investments simply by dying. This practice, known as "stepped-up basis," allows heirs to inherit assets with a value reset to the market price at the time of death, effectively erasing any capital gains tax liability on the appreciation that occurred during the deceased's lifetime. This loophole costs the U.S. Treasury an estimated $70 billion annually and disproportionately benefits the wealthiest Americans.
Under current law, if an individual buys an asset for a certain price and its value increases significantly, they would owe capital gains tax if they sold it. However, if they hold onto the asset until death, their heirs can inherit it without owing tax on that accumulated gain. The tax code treats the heir as if they purchased the asset at its market value on the date of inheritance. For example, if a billionaire's stock, purchased for $10 million, is worth $110 million at their death, their heir could immediately sell it for $110 million and owe no capital gains tax on the $100 million profit.
This stepped-up basis rule not only reduces government revenue but also complicates efforts to equalize tax rates on investment income with those on labor income. Proposals to increase the top capital gains tax rate to 39.6%, aligning it with the top income tax rate, could be less effective or even revenue-neutral if the stepped-up basis loophole remains. Economists have projected that without stepped-up basis, a capital gains tax hike could generate considerably more revenue, as investors would be incentivized to sell assets rather than hold them indefinitely to avoid taxation.
The policy also creates economic inefficiency by discouraging the reallocation of capital. Wealthy investors are incentivized to keep capital locked in assets until death, even if other investments might offer greater returns or societal benefit. This can hinder market dynamism and the efficient flow of capital to more productive enterprises.
Addressing the Loophole
One proposed solution is to implement a "carryover basis" system, where heirs would assume the deceased's original cost basis. In the previous example, the heir inheriting the $110 million stock would owe capital gains tax on the $100 million profit. However, a more impactful approach, according to analysis, is to treat death as a taxable event, equivalent to selling the assets. Under this policy, the deceased's unrealized capital gains would be calculated and added to their final tax return.
This method would generate significantly more revenue than carryover basis. Estimates suggest taxing accrued gains at death could raise $536 billion over a decade, compared to $197 billion from carryover basis alone. A key advantage is that it collects taxes immediately upon death, rather than allowing heirs to defer payments indefinitely.
Arguments against taxing gains at death often cite concerns about forcing the sale of family businesses. However, proponents suggest that closely held businesses could be offered installment payment options for their tax liabilities. Furthermore, research indicates that businesses run by heirs may underperform those led by unrelated executives, suggesting that preserving dynastic ownership may not be a primary objective for tax policy.
Alternative and Complementary Strategies
Taxing unrealized capital gains annually is another progressive proposal that could address some of the same issues. Under this system, individuals would pay taxes on investment appreciation each year, regardless of whether assets are sold. This would prevent the deferral of taxes and the erosion of tax liability due to inflation, which can occur when taxes are paid decades after gains are realized.
However, legal analysts suggest that annual taxation of unrealized gains might face constitutional challenges from the Supreme Court. Taxing accrued gains at death, conversely, is seen as more likely to withstand legal scrutiny because death itself is a taxable transfer of assets.
Closing the death loophole is also considered to have fewer logistical challenges than annually valuing all of an individual's assets, particularly hard-to-price private holdings. Valuations would only be necessary once, at the time of death, when estates are already required to inventory and appraise assets for inheritance and estate tax purposes.
Despite the potential benefits, closing the death loophole has faced political resistance. Previous attempts by the Biden administration to address it were reportedly vetoed by moderate Democrats. Proponents argue that making the taxation of deceased billionaires' capital gains a politically prominent issue is crucial for its eventual passage.