Change the Tax Treatment of Capital Gains From Sales of Inherited Assets
CBO periodically issues a compendium of policy options (called Options for Reducing the Deficit) covering a broad range of issues, as well as separate reports that include options for changing federal tax and spending policies in particular areas. This option appears in one of those publications. The options are derived from many sources and reflect a range of possibilities. For each option, CBO presents an estimate of its effects on the budget but makes no recommendations. Inclusion or exclusion of any particular option does not imply an endorsement or rejection by CBO.
|Billions of Dollars
|Change in Revenues
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 typically calculated as the sales price minus the asset's adjusted basis—generally the price at the time it was initially acquired plus the cost of any subsequent improvements, 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. To calculate the gains on inherited assets, taxpayers generally use the asset's fair-market value at the time of the owner's death—often referred to as stepped-up basis—instead of the adjusted basis derived from the asset's value when the decedent initially acquired it. As a result, when the heir sells the asset, capital gains taxes are assessed only on the change in the asset's value 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.)
Generally, capital gains resulting from the sale of inherited assets are taxed at the long-term capital gains rate that applies to assets held for more than one year, regardless of how long the heir has held the asset. There is not enough publicly available information to measure the share of long-term capital gains that results from sales of inherited assets. However, in total, 11 million taxpayers reported $635 billion in net long-term capital gains on their 2016 tax returns, and 8 million taxpayers reported $334 billion in net long-term capital losses. The Congressional Budget Office projects that income from capital gains will decline between 2019 and 2021 and then increase between 2022 and 2028.
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 gain 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 the 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.)
Effects on the Budget
If implemented, this option would increase revenues by $105 billion from 2019 through 2028, the staff of the Joint Committee on Taxation estimates. That estimate incorporates the response by some heirs to the change in the tax treatment of the sales of inherited assets. 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 the sales of inherited assets (as they might for assets they purchased themselves) to defer capital gains taxes and thereby reduce their tax liability.
The estimate for this option is uncertain for two primary reasons. First, the estimate relies on CBO's economic projections, including those of the value of assets at their owners' death and of capital gains realizations, and such projections are inherently uncertain. Second, the estimate reflects taxpayers' anticipated responses to the change in the tax treatment of inherited assets, including delays in the sales of those assets, which are also uncertain.
One advantage of this option is that it would encourage people to shift investments to more productive uses during their lifetimes, rather than retaining those assets so that their heirs can 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. 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, which could be particularly problematic for nonliquid assets.
Another advantage is that using carryover basis to determine capital gains would decrease people's incentives 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 so that they can fund their current consumption and, after their death, the loan can be repaid with 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, though they would probably reduce the amount of revenues raised. 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, to minimize the costs of recordkeeping, appreciated assets in estates that are valued below a certain threshold could be exempted from the carryover basis treatment (and the heirs could continue to use the stepped-up basis).