Deferral and Forgiveness of Tax on Unrealized Capital Gains

When assets such as real estate or stock shares appreciate in value, those gains--according to definitions commonly used by economists--are potentially taxable income. But the policymakers who first enacted the income tax recognized the practical difficulties of collecting tax on unrealized income and chose to tax those gains only when the assets were sold. Because of the time value of money, such a deferral lowers the effective tax rate on the gains to less than the taxpayer's statutory rate.

The tax deferral applies to capital losses as well as to capital gains. Because deferring capital losses reduces their value to the taxpayer, taxpayers thus have an incentive to realize losses in the year that they occur (just as the tax deferral on gains encourages taxpayers to hold assets because it increases the gains' value). To deter such behavior, legislators instituted a limit of $3,000 on the amount of capital losses that can be used to offset ordinary income in any one year. Losses in excess of that limit, however, may be carried over to later years.

If a taxpayer holds on to an asset until he or she dies, the law forgives the deferred taxes altogether. That feature of capital gains taxation, known as the step-up in basis at death, has also existed since the onset of the income tax. Heirs owe income tax only on those gains that accrue after the death of the assets' original owner, although the value of the assets at the time of death is included in the decedent's gross estate and therefore is potentially taxable under the estate tax.⁽¹⁾