A Capital Idea

The House of Representatives’ vote last week to repeal the estate tax might have looked like it would end the death-tax wars, but never fear. Opponents of the permanent tax cut aren’t going gently into that good night, and they’re poking holes in the current bill that might initially appear pretty serious. So it’s important to remember that appearances can be deceiving, especially when it comes to the prickly matter of capital gains and estate taxes.Take the brewing “carry-over basis” storm. Estate-tax fans point to an arcane provision of the tax bill under debate to argue that it will hurt the common folk while benefiting the spectacularly wealthy. In reality, this is a rare example of Congress introducing more fairness and common sense into the tax law, almost despite itself. We should be celebrating.The question is how to value capital assets in an estate. Ordinarily, capital gains are counted as the appreciation of an asset over the time the taxpayer owns it. But current inheritance taxes offer a loophole. If you die with a stock in your hand, your heirs get to value their capital gain on that stock as the appreciation on the value of the asset when they inherit it. That is, if you bought the share at $25, died when it was at $50, and then your kin sold it at $75, their capital gain is only $25 – the difference between their take and what it was worth when it passed down to them.That system of valuation is called “step-up basis,” because the basis for assessing capital gains steps up when the original owner dies. The bill currently before the Senate eliminates this loophole by using a “carry-over basis” for capital gains taxes on inherited assets. Going back to the example above, your survivors would now be on the hook for the full $50 in capital gains.Supporters of the death tax are latching on to this change as a silver bullet to kill reform. After all, they say, the change will expand the tax man’s reach to people who currently don’t have to worry about estate taxes, and will especially hurt surviving spouses who would now face higher tax bills than otherwise, or even a tax bill where there wouldn’t have been one before.But that line of argument masks some of the deeper issues involved. First, the relatively small number of people who actually pay estate taxes right now pales in comparison to the probably large number of people who are affected by them. That large group only avoids paying the taxes because the current systems gives them ample incentives to expend lots of time and money crafting wealth-management strategies to reduce, or even eliminate, their tax liabilities. Even if it expands the reach of capital gains taxation, the current bill does so in an entirely predictable way. It is much easier for individuals to prepare for a capital gains tax hit than it is to navigate the death-tax minefield. If Democrats on the Hill are so unhappy about this move, perhaps they should consider reducing capital gains tax rates.Second, the current step-up regime creates perverse incentives for investors. The older they get, the more incentive they have to hang on to assets they might otherwise be well advised to sell off, simply because the step-up system will reward them for holding by providing a way to avoid capital gains taxes.Proponents of step-up accounting do raise a practical question – it can be difficult to uncover the original value of a capital asset if the original purchaser is dead. But that’s not much of an argument. The only reason an investor might not keep such records now is that step-up accounting provides no reason to do so if you expect to hold the asset until you pass away.We aren’t deluding ourselves about why Congress is so keen to make this change: It will help replace some of the revenue that will be lost to the permanent elimination of the estate tax. But a happy consequence of their rapacity turns out to be a simpler, fairer, more predictable tax code. Where’s the problem?

A Capital Idea

A Capital Idea

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