Change the Tax Treatment of Capital Gains From Sales of Inherited Assets

When people sell an asset for more than the price at which they obtained it, they realize a net capital gain. That net gain is generally calculated as the sales price minus the asset's adjusted basis. The adjusted basis is generally the price of the asset at the time it was initially acquired plus the cost of any subsequent improvements and minus any deductions for depreciation. Net capital gains are included in taxable income in the year in which the sale occurs.

The tax treatment of capital gains resulting from the sale of inherited assets is different. Taxpayers who inherit assets generally use the asset's fair-market value at the time of the owner's death to determine their basis—often referred to as stepped-up basis—instead of the adjusted basis derived from the time the decedent initially acquired the asset. As a result, when the heir sells the asset, capital gains taxes are assessed only on the change in the asset's value that accrued after the owner's death. Any appreciation in value that occurred while the decedent owned the asset is not included in taxable income and therefore is not subject to capital gains taxation. (However, the estate may be subject to the estate tax.)

Under this option, taxpayers would generally adopt the adjusted basis of the decedent—known as carryover basis—on assets they inherit. As a result, the decedent's unrealized capital gains would be taxed at the heirs' tax rate when they eventually sell the assets. (For bequeathed assets that would be subject to both the estate tax and capital gains tax, this option would adjust the basis of some of those assets to minimize the extent to which both taxes would apply to the appreciation in value.) If implemented, this option would increase revenues by $68 billion from 2017 through 2026, the staff of the Joint Committee on Taxation estimates.

Under the option, most gains accrued between the date a person initially acquired the asset and the date of that person's death would eventually be taxed. As a result, the tax treatment of capital gains realized on the sale of inherited assets would be more similar to the tax treatment of capital gains from the sale of other assets.

One advantage of this approach is that it would encourage people to shift investments to more productive uses during their lifetimes, rather than retaining them so that their heirs could benefit from the tax advantages offered by the stepped-up basis. The option, however, would not completely eliminate the incentive to delay the sale of assets solely for the tax advantages. For an asset that rose in value before the owner's death, replacing stepped-up basis with carryover basis would increase the total amount of taxable capital gains realized when the asset is sold by the heir (unless the asset's value dropped after the owner's death by an amount equal to or greater than the appreciation that occurred while the owner was alive). As a result, heirs might choose to delay sales to defer capital gains taxes (as they might for assets they purchased themselves). An alternative approach would be to treat transfers of assets through bequest as a sale at the time of the transfer, making the capital gains taxable in that year. However, that method might force the owner to sell some portion of the assets at an inopportune time to pay the tax and could be particularly problematic for nonliquid assets.

Another advantage is that using carryover basis to determine capital gains would decrease the incentive for people to devote resources to tax planning rather than to more productive activities. For example, it would lessen the advantages of using certain tax shelters that allow people to borrow against their assets for current consumption and for the loan to be repaid after their death by using the proceeds from the sale of their assets.

A disadvantage of this option is that heirs would find it difficult to determine the original value of the asset when the decedent had not adequately documented the basis of the asset. Additional provisions could be enacted to make it easier to value an asset. For example, heirs could have the choice of using carryover basis or setting the basis of an inherited asset at a specified percentage of the asset's value at the time they inherit it. Alternatively, appreciated assets in estates that are valued below a certain threshold could be exempt from the carryover basis treatment to minimize the costs of recordkeeping.