Tax Treatment of Capital Gains at Death

Tax Treatment of Capital Gains at Death

Updated June 4, 2021
Tax Treatment of Capital Gains at Death
When an asset is sold that has appreciated in value, such as
Potential Revisions in the Tax
a share of stock, the gain is taxed at rates of 0%, 15%, or
Treatment of Capital Gains at Death
20%, with the top rate applying in 2021 when incomes
Two proposals have been made for changing the tax
exceed $501,600 for a joint return and $445,850 for a single
treatment of capital gains at death: adopting carryover basis
return. These income levels are adjusted for inflation. The
and taxing capital gains at death.
rates apply to an asset held for at least one year (referred to
as long-term capital gains); otherwise, gains are subject to
Carryover Basis
ordinary rates (the top rate is 37%). An additional 3.8% tax
Under carryover basis, an asset inherited at death would
applies to capital gains (as well as other passive income)
retain the basis in the hands of the decedent. In this case,
when incomes reach $250,000 for a joint return and
the gain would not escape taxation but would be subject to
$200,000 for a single return.
tax when and if the heir sold the asset.
Capital gain subject to tax is the difference between the
Carryover basis has been proposed as far back as 1942 and
sales price and the basis of the asset. For most assets (such
in two instances has been enacted into law. The first
as stocks), the basis is the price paid for the asset. In the
instance was in 1976, although the law was retroactively
case of depreciable assets, the basis is lower than the
repealed in 1980 and never took effect. The second instance
acquisition cost due to depreciation. The part of the gain
was in 2010. In the Economic Growth and Tax Relief
attributable to depreciation taken is taxed at ordinary rates.
Reconciliation Act of 2001 (P.L. 107-16), the estate tax was
See CRS Report 96-769, Capital Gains Taxes: An
scheduled to be reduced and eliminated entirely in 2010 to
Overview, by Jane G. Gravelle for further discussion.
be replaced by carryover basis. Although the estate tax was
restored, executors in that year could elect to pay the estate
Currently, the capital gains tax is not levied on assets held
tax or choose carryover basis, with a $1.3 million
until death. These assets are included in the estate at market
exemption. Estimates from researchers at the Department of
value and subject to estate taxes of 35% after a significant
the Treasury indicated that 60% of estates opted for the
exemption (by historical standards) of $11.7 million, as
carryover basis.
well as other exclusions. (The exemption was doubled in
2017 legislation, P.L. 115-97, and that increase will expire
In December 2019, Senators Romney and Bennet proposed
after 2025 unless the law is changed.) The basis for these
carryover basis with an exemption of $1.6 million for
assets is the market value at death, referred to as a step-up
singles and $3.7 million for married couples, although this
in basis. See CRS Report R42959, Recent Changes in the
plan was never introduced as legislation.
Estate and Gift Tax Provisions, by Jane G. Gravelle for
further discussion of the estate tax.
The revenue gain from a carryover basis regime would rise
over time as heirs sell assets. In its 2020 Budget Options
Proposals have been made to change step-up basis,
report, the Congressional Budget Office estimated that
including a Biden budget proposal to tax capital gains
adopting carryover basis beginning in 2021 would raise
transferred at death or by gift.
revenue by $110 billion from FY2021 to FY2030, rising
from $1.2 billion in FY2021 and $4.8 billion in FY2022
Current Law for Assets Held Until
(the first full year) to $18.4 billion in FY2030.
Death: Step-Up Basis
Under current rules, when an asset is transferred at death,
Taxation of Capital Gains at Death
the basis is stepped up to the market value at the time of
Another alternative for the treatment of capital gains at
death. If the heir sells the asset, the gain subject to tax
death is to treat death as a realization event (that is, treated
would be the appreciation that occurred since inheriting the
as if the decedent had sold the asset in the last year of life)
asset. Thus, the gain of the asset in the hands of the
and tax capital gains at that time. The heirs would increase
decedent would never be subject to income taxes. (Assets
the basis by the gains (i.e., their basis would be market
transferred by gift retain the original basis of the donor.)
value at time of death, the same as under present law). The
estate value would be reduced by the capital gains tax paid.
Because of this step-up rule, one justification for the estate
tax has been as a backstop to the escape from the capital
Proposals to tax capital gains at death date back to President
gains tax, although the estate tax is now subject to a
Kennedy in 1963 and were proposed by the Ford and the
historically large exclusion and less effective in performing
Obama Administrations.
a backstop rule than in the past. In 2019, 6,409 estates were
subject to the estate tax—a decline of nearly 60% since
2010.
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Tax Treatment of Capital Gains at Death
Canada has taxed capital gains at death since 1971 but has
large current exemptions making it less effective for this
no national estate tax, while Australia, Ireland, and the
purpose.
United Kingdom tax capital gains transferred by gift.
A related argument for adopting carryover basis or taxing
H.R. 2286 (Pascrell) and a proposal by Senators Van
gains at death is that the current treatment is viewed as a
Hollen, Booker, Sanders, Warren, and Whitehouse (not yet
major reason for the lock-in effect; that is, the tendency to
introduced as legislation) would tax capital gains at death,
hold on to assets to avoid the capital gains tax. This effect
with an exemption for the first $1 million of gain. Several
not only leads to distortions in portfolio choice and liquidity
bills in the 116th Congress—H.R. 8352 (Bass), H.R. 3922
but also limits the potential for increasing revenue yield by
(Pressley) and S. 2231 (Booker)—would have taxed capital
raising capital gains tax rates on realized gains, which are a
gains at death. These bills had a smaller exemption of
large part of the income of high-income individuals. While
$100,000, with a $1,000,000 exemption for farm property
there is disagreement about the magnitude of behavioral
(to be recovered if the farm property were sold within 10
responses (see CRS Report R41364, Capital Gains Tax
years).
Options: Behavioral Responses and Revenues, by Jane G.
Gravelle), a significant offset from the revenue gained on a
The Biden budget proposal would raise the capital gains
static basis is likely when capital gains tax rates are raised,
(and dividend) tax rate to the top ordinary rate for taxpayers
particularly if they were to be raised to ordinary rates.
with incomes over $1 million for married couples and
$500,000 for singles. The current top rate is 37%, raised to
For addressing these objectives, taxation at death is a more
39.6% after 2025 under current law, but there is also a
effective approach, and the option of carryover basis would
budget proposal to raise the rate to 39.6%. The 3.8% tax on
allow wealthy family dynasties to avoid capital gains
net investment income would continue to apply. The budget
taxation indefinitely.
plan would also tax capital gains at death or by gift with a
$2 million exemption for married couples and a $1 million
Arguments against Revision
exemption for singles. Gains on assets given to spouses and
For both approaches, a traditional argument, especially
charities would not be taxed. Gain on family businesses
important in retroactively repealing the carryover basis
would not be taxed as long as the business remains with the
enacted in 1976, has been the concern about measuring
heirs, and gains on non-liquid assets could be paid over a
basis. Generally, the executor of the will, who is
15-year period. The combined higher rates and taxation at
responsible for paying the tax, did not actually hold the
death or by gift is projected to yield $332 billion over
assets. Although taxpayers are responsible for keeping track
FY2022-FY2031.
of basis, they may not have done so if they expected the
heirs to benefit from stepped-up basis. One option for this
According to the Joint Committee on Taxation, the
issue is to allow a safe harbor basis of a certain percent of
exclusion of capital gains at death costs $40 billion per
the asset’s market value.
year, although this amount would be substantially reduced
with a large exemption. A study in 2013 found that an
A second criticism, which applies to the option of taxing
exemption of $1.3 million (indexed) would reduce the yield
capital gains at death, is liquidity and the potential for
by 45%.
forced sales of assets, such as family businesses. This issue
already exists under the estate tax and is partially addressed
Issues in the Tax Treatment of Capital
by allowing payment of the tax in installments. One
Gains at Death
proposal by Harry Gutman, former chief of staff of the Joint
Committee on Taxation, would apply the tax only to
Arguments for Revision
marketable securities, with family businesses subject to
Failure to tax capital gains unless realized allows high
carryover basis, taxation at the rate applicable to the
income taxpayers to significantly reduce, especially at high
decedent, and with an interest charge for the deferral of tax.
income levels, their effective tax rates. These taxpayers
have a major portion of their income from capital income,
A third criticism is the additional complexity of taxing
and a significant share is estimated to be from unrealized
capital gains at death. This concern could be addressed by
capital gains. The step-up basis is viewed as a main
providing an exemption adequate to confine the tax to
contributor to that effect.
wealthy individuals with resources to deal with tax
complexity.
As noted earlier, the estate tax often has been viewed as a
backstop for the failure to tax unrealized capital gains and
Jane G. Gravelle, Senior Specialist in Economic Policy
other types of income that escape income taxes, with the
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Tax Treatment of Capital Gains at Death

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