I remember when I was young, my dad would often say that the only things we “had” to do in this world were eat, sleep, and pay taxes; the rest was up to us. As I grew older, I realized that in many ways, he was right. When you go to the store and buy something, you pay sales tax, when you work and earn money, you pay income tax, and when you put gas in your car, chances are you’re paying a road tax or two.
Even when you’re going through the process of estate planning, it’s important that you consider the tax implications of your decisions. After all, when you die, you don’t want the estate taxes paid by your heirs to cut too deeply into what you leave behind for them.
You may have heard about tax loopholes ultra-wealthy people use to produce tax breaks, but you might be surprised that one of these loopholes is relatively simple for just about anyone with investment assets to take advantage of while planning their estates.
It’s known as the stepped-up basis loophole, the stepped-up basis rule, or the cost-basis loophole, depending on who you talk to. No matter what you call it, if you plan on leaving investment assets to your heirs, taking advantage of the loophole will ease the burden when the IRS comes knocking after your assets have been transferred.
What Is a Step-Up in Basis?
The stepped-up basis loophole is part of the tax code that applies to inherited assets such as stocks, bonds, mutual funds, real estate, and other investment property. The loophole is based on how capital gains taxes are calculated.
The IRS taxes investors on the amount of money they earned (profits) based on their purchase price (cost basis) and the market value of the asset upon the sale of the asset. If you buy 100 shares of ABC stock at $100 per share, your cost basis is $10,000. If the stock grows to $150 per share and you sell your shares for $15,000, you’ll pay capital gains taxes on $5,000, or your profits on the transaction.
However, the stepped-up basis rule stipulates that, for tax purposes, the cost basis of inherited appreciated assets are adjusted to the fair market value at the time of the original owner’s death. This means that as far as the IRS is considered, the heir that inherited the assets obtained them at their value at the time of transfer, rather than at the original cost of the assets.
As a result, heirs don’t pay capital gains taxes on the growth in the value of the asset during the original owner’s life; they simply pay taxes on gains from the date the assets are transferred to them.
How the Stepped-Up Basis Loophole Works
The best way to explain how the stepped-up basis loophole works is to give you an example.
Let’s say Joe is planning his estate, which includes 1,000 shares of ABC stock he wants to leave to an heir. Joe originally purchased these shares for $100 each, creating a cost basis of $100,000. Today, the shares are worth $200,000 thanks to the growth they’ve experienced over the past decade.
When considering the shares of ABC stock in his estate, he’s got two options surrounding how the assets are transferred.
Option #1: Cash Transfer (Voids the Stepped-Up Basis)
The first option Joe can use is a cash transfer. Through this process, when Joe dies, his holdings in ABC stock will be liquidated at a fair-market value. Upon the liquidation, the estate will owe tax on the capital gains at the current capital gains tax rate. For simplicity’s sake, let’s say that rate is 15%.
Before the cash is transferred to Joe’s heir, the 15% tax would be deducted from the cash total. Since the investment was worth $100,000 when Joe purchased it and had grown to $200,000 at the time of his death, the gains — $100,000 — would be taxed at the 15% capital gains rate, working out to a tax of $15,000.
As a result, Joe’s heir would receive a net payment of $185,000 as their inheritance.
Option #2: Asset Transfer (Takes Advantage of the Loophole)
The second option is for Joe to transfer his stake in ABC to his heir as it stands. In doing so, his heir would benefit from a step-up in basis. Upon Joe’s death, the shares of ABC would be transferred directly to his heir with no cash transaction taking place.
At this point, Joe’s heir would benefit from the IRS calculating a new cost basis based on the current value of the shares at the time of the transfer. This means that instead of Joe’s heir receiving $185,000 in cash, they would receive the full $200,000 in stock.
If the heir was to sell that stock right away for $200,000, it would be a tax-free transaction. Once the IRS stepped up the cost basis of the stock to $200,000, as far as the IRS is concerned, there were no capital gains generated from the heir’s transaction.
Why Does This Rule Exist?
While millionaires and billionaires often take advantage of a step-up in basis in their estate tax plan, it wasn’t necessarily designed for this purpose. In fact, many argue that the uber rich abuse this rule.
The stepped-up basis rule was originally designed to give families that owned farms and other businesses a way to pass their livelihoods down to their children, keeping their businesses in the family without the fear of a tax burden-related closure of the company.
For example, before the loophole was created, if Joe wanted to pass down his family farm to his son, he could, but the son would have to pay capital gains taxes on the entire increase in the value of the family farm from the date Joe first owned it. In some cases, those taxes were so large that heirs were forced to sell their family’s livelihood just to pay the taxes.
The stepped-up basis rule made it so that when Joe passed the farm down to his children, the farm’s cost basis would be adjusted based on the fair market value on the date of Joe’s death, meaning there would be no exorbitant tax bill due when the heir inherited the business.
Criticisms of Stepped-Up Basis
Although the stepped-up basis rule has done wonders for many heirs of family-owned businesses, allowing them to remain in existence and family owned to this day, the rule has come under scrutiny over the past several years.
Some argue that the way the current law is written provides millionaires and billionaires a way to game the system that’s simply unfair to the average American. There’s validity to the argument too.
The stepped-up basis rule creates an incredible incentive for the uber-rich to buy and hold assets until after their death. Through this process, the uber-wealthy are able to hand down hundreds of thousands, even millions more dollars than they would have if their estates had cashed out their investments and paid long-term capital gains taxes.
So, what’s the problem with that?
According to Forbes, the top 1% wealthiest people in the United States are in control of a whopping 30.4% of the nation’s wealth. If all of these people hold their money in assets like stocks and real estate and use a step-up in basis for their heirs, there are two big consequences that follow:
It Starves the U.S Government of Billions in Tax Revenue
Taxes provide the funding that fuels the federal government. At the moment, total U.S. household net worth sits at $142 trillion, according to MarketWatch. That means the 30.4% of the nation’s wealth owned by the wealthiest one-percent works out to more than $43 trillion in total.
If $43 trillion was charged a tax rate of even 10% when this wealth was transferred in an inheritance, it would add $4.3 trillion in receivables for the U.S. government. That’s $4.3 trillion that wouldn’t have to be raised from everyone else through other forms of federal taxes, such as income taxes, likely reducing the tax burden for the average American.
However, this loophole allows a large majority of that wealth to pass through as investment assets, meaning there’s no tax charged.
It Starves the U.S. Economy of Spending
To take advantage of this tax loophole, many wealthy individuals sock large percentages of their money away in investment assets, with the intent of holding onto them until they die. That’s money that could be used to help spur economic development.
Sure, you can’t expect the uber-rich to spend every penny they have. If they did that, they wouldn’t hold onto their wealth. However, without this loophole leaving so much money tied up in investments, the abundantly wealthy people in the country would potentially spend more money, leading to more opportunities for all.
Proposals to Close the Stepped-Up Basis Tax Loophole
With widespread criticism of the stepped-up basis tax loophole, many politicians, especially in the Democratic Party, are racing to change the tax code. President Joe Biden has produced multiple proposals that involve closing the loophole, but they are awaiting a vote in Congress.
Biden’s proposal known as the American Families Plan (AFP) would largely eliminate the loophole if passed, although there is no set time or date for the vote on the plan in Congress just yet.
If it passes, however, the Biden Administration will notch a major win. The plan is aimed at improving opportunities for all Americans by extending tax cuts to lower- and middle-income families, providing additional education, and providing paid leave and child care support for families and workers.
These benefits sound great, but they would be expensive. A major source of funding for Biden’s tax plan involves partially closing the stepped-up basis loophole. If the plan goes through, inheritances worth more than $1 million will no longer be able to use this loophole. Instead, the plan includes other protections for family farms and family-owned businesses being passed down to heirs.
The stepped-up basis loophole is one that’s used by countless families in the estate planning process across the nation. While the loophole saves many Americans from massive inheritance tax burdens, there’s a strong argument that the loophole creates an unfair advantage for the ultra-wealthy, which not only starves the government of much needed funding, but also starves the U.S. economy of a significant amount of spending.
While there are naysayers, it’s important to keep in mind that the loophole still exists at present. As long as it’s out there, it’s important to consider it in your estate planning activities.