Step-Up vs. Carryover Basis for Capital Gains: Implications for Estate Tax Repeal

Step-Up vs. Carryover Basis for Capital Gains: Implications for Estate Tax Repeal

Order Code RL30875
CRS Report for Congress
Received through the CRS Web
Step-Up vs. Carryover Basis for Capital Gains:
Implications for Estate Tax Repeal
Updated April 20, 2001
Nonna A. Noto
Specialist in Public Finance
Government and Finance Division
Congressional Research Service ˜ The Library of Congress

Step-Up vs. Carryover Basis for Capital Gains:
Implications for Estate Tax Repeal
Summary
Current income tax law provides for a “step-up” in the basis of an inherited asset
to its fair market value at the time of the decedent’s death. When the heir sells the
asset, the capital gain for income tax purposes is measured by the difference between
the heir’s selling price and the stepped-up basis of the asset. (The basis is no longer
the asset’s cost at the time when the decedent acquired it. That would be known as
a “carryover” basis.) As a result, there is no income tax liability on the appreciation
in the asset’s value during the decedent’s period of ownership (lifetime) – for the
decedent as well as the heir.

If the federal estate tax were repealed but the step-up in basis of assets at death
continued, the appreciation in value of capital assets during a decedent’s lifetime
could avoid both the estate tax and the income tax. If the estate tax were repealed
but inherited assets received a carryover rather than stepped-up basis, a capital gains
tax would be due on this appreciation in value when the assets were sold by the heirs.

As shown by numerical examples, estates that are subject to substantial estate
tax liability under current law would face a much lower overall tax liability under an
exchange of the estate tax for a capital gains tax on inherited assets. However, for
estates which are not subject to estate tax liability under current law, repealing the
estate tax in exchange for a carryover basis could mean an increase in income tax
liability on capital gains relative to current law for heirs, unless a step-up in basis was
preserved for some amount of a decedent’s assets. (The estates of most decedents
do not face an estate tax liability under current law, primarily because assets of
married decedents often pass to the surviving spouse under the unlimited marital
deduction, and/or because the remaining assets are less than the estate tax exclusion
amount of $675,000 in 2001, rising to $1 million by 2006.)
Most bills to repeal the estate tax would retain the current unlimited step-up in
basis. However, a few bills would institute a carryover basis for inherited assets in
exchange for repealing the estate tax. H.R. 8 (as passed by 106th Congress, but
vetoed by President Clinton in August 2000) would have replaced the step-up in basis
with a carryover basis when the estate tax was fully repealed, with a limited amount
of assets entitled to receive the step-up in basis. H.R. 8 (Dunn and Tanner) was
reintroduced in the 107th Congress, substantially amended by the Ways and Means
Committee, and passed by the House on April 4, 2001. The new bill retains the
previous step-up exceptions of $1.3 million for transfers to any beneficiaries plus $3
million to a surviving spouse. For a nonresident alien decedent, the step-up is limited
to $60,000 rather than $1.3 million. H.R. 8 (107th) also makes the exclusion of
$250,000 per person for the capital gain on the sale of a principal residence available
to the heir. S. 275 (Kyl) would repeal the estate tax, retain a step-up in basis for $2.8
million in assets, and provide a carryover basis for assets in excess of that limit. There
are many questions about how either a carryover or step-up in basis of inherited assets
could be administered in the absence of a federal estate and gift tax. This report will
be updated to reflect other bills introduced in the 107th Congress to change the estate
tax and the accompanying basis rules for inherited assets.

Contents
Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Current Tax Law Regarding Basis and Capital Gains . . . . . . . . . . . . . . . . . . . . . 1
Capital Gains Tax and Step-up in Basis for Inherited Assets . . . . . . . . . . . . 1
Numerical example of capital gains tax liability on an inherited asset with
a step-up in basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Carryover Basis for Gifted Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Numerical example of capital gains tax liability on a gifted asset with a
carryover basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Discussion of Policy Issues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Taxing Unrealized Appreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Taxation at Death or When Assets Are Sold . . . . . . . . . . . . . . . . . . . . . . . 5
Alternative Approaches to Taxing Unrealized Capital Gains . . . . . . . . . . . . 5
Replacing the Estate Tax with Full Carryover Basis for Inherited Assets . . 6
Numerical Example of Trading Off the Estate Tax for Full Carryover Basis,
for an Estate Now Liable for Estate Tax . . . . . . . . . . . . . . . . . . . 7
Numerical Example of Why Estates Not Liable for Estate Tax under
Current Law Could Be Worse Off under Estate Tax Repeal with Full
Carryover Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Administrative Concerns in Establishing Basis . . . . . . . . . . . . . . . . . . . . . 10
Bills to Restrict the Step-Up in Basis in Exchange for Repealing the Estate Tax
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
106th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
H.R. 8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
107th Congress . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
H.R. 8 (Passed by the House) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
H.R. 627 (Boehner)/ S. 333 (Lugar) . . . . . . . . . . . . . . . . . . . . . . . . . 13
S. 275 (Kyl) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
List of Tables
Table 1. Capital Gains Tax Due at Sale on Inherited Asset with Stepped-up Basis vs.
Gifted Asset with Carryover Basis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Table 2. Estimated Revenue Gains from Including Capital Gains in Decedent’s Last
Income Tax Return and from Enacting a Carryover Basis for Capital Gains Held
Until Death, FYs 2002-2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6
Table 3. Tradeoff of Estate Tax for Full Carryover Basis and Capital Gains Tax
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

Step-Up vs. Carryover Basis for Capital
Gains: Implications for Estate Tax Repeal
Policy Issues
If the federal estate tax were repealed but the step-up in basis of assets at death
continued, the appreciation in value of capital assets during a decedent’s period of
ownership (lifetime) could avoid both the estate tax and the income tax on capital
gains – for the decedent as well as the heir. Several basic policy questions arise:

! If the estate tax is repealed, should the appreciation in the value of assets
during a decedent’s lifetime be subject to tax?
! If the appreciated value is to be taxed, when should it be? At the time of the
person’s death, or only when the assets are sold by heirs?
! What are the overall tax implications of trading off a repeal of the estate tax for
a repeal of the step-up in basis? Are the tradeoffs different for large (taxable)
estates than for smaller (nontaxable) estates?
! What are the administrative concerns about administering either a step-up or
carryover basis, in the absence of an estate tax?
Current Tax Law Regarding Basis and Capital
Gains
Under current tax law, assets transferred at death receive a step-up in basis,
while assets transferred as a gift (inter vivos, while the giver is alive) retain a
carryover basis. The basis affects the capital gains tax due when the heir or gift
recipient sells the asset. This section provides an explanation of these two cases and
some simple numerical examples, which are summarized in Table 1. (This part of the
report does not address the estate and gift taxes that may also be due on the transfer
of assets, either at death or during the giver’s lifetime, for estates large enough to be
liable for estate and gift taxes.)
Capital Gains Tax and Step-up in Basis for Inherited Assets
The capital gains tax is part of the income tax, not the estate tax. In the context
of the estate tax, capital gains taxes are the concern of heirs who want to sell or
liquidate assets they inherit. A capital gains tax only becomes due when an asset is
sold by an heir or, as tax practitioners say, when the gains are “realized.” No income
tax is owed as long as an heir continues to hold an inherited asset, or passes it along
to future generations. The capital gains tax is levied on the profit or “net gain” on the
sale, measured by the difference between the sales proceeds and the cost or “basis”
of the asset.

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In contrast, the estate tax is calculated starting with the “gross” current market
value of assets owned at the time of a person’s death.1 This typically includes some
if not substantial “unrealized” capital gains on appreciable assets.2 One defense of the
estate tax is that it serves as a backup to the income tax by taxing the unrealized
capital gains that accrued during the decedent’s period of ownership (lifetime) and
that will not be subject to the income tax even when realized by the heirs, for the
following reason.
In what can be considered as a partial tradeoff for the estate tax, the income tax
law permits a so-called “step-up” in the basis of inherited assets.3 For the heir or
recipient, that means the basis becomes the fair market value of the asset at the time
of the decedent’s death.4 When the heir sells the asset, the capital gain for income tax
purposes is measured by the difference between the heir’s selling price and the
stepped-up basis of the asset. (This is in contrast to using the decedent’s basis,
generally the cost of the asset when originally purchased by the decedent, which
would be known as the “carryover” basis.) As a result, any gain in the asset’s value
during the decedent’s lifetime is permanently forgiven from the income tax on capital
gains.5
Numerical example of capital gains tax liability on an inherited
asset with a step-up in basis. Assume that a man purchased stock in 1980 for
$100. When he died in 1999, the market value of the stock was $1,000. This $1,000
value becomes the stepped-up basis of the stock. Assume that his son, who inherited
the stock, sold it in 2000 for $1,100. Also suppose that the man and his son both
faced a capital gains tax rate of 20%.
If the man had sold the stock for $1,000 just before he died in 1999, he would
have owed a capital gains tax of $180. The $180 is equal to a 20% tax on the $900
in capital gains during his period of ownership ($1,000 - $100 = $900). (See “Sale
by Original Owner Before Death” in the first column of Table 1.)
1Certain deductions are permitted from the gross estate in determining the taxable estate, such
as the marital deduction, charitable deduction, deduction of expenses for the funeral and the
administration of the estate, and payment of debts of the decedent.
2Not all assets are appreciable and therefore candidates for a step-up in basis. For example,
bank accounts or savings bonds are not subject to a capital gain (or loss).
3The step-up in basis also applies to assets transferred to a surviving spouse under the
unlimited marital deduction.
4The value of an estate’s assets may be established either as of the decedent’s date of death
or the alternate valuation date, six months later, if the value of the gross estate and the estate
tax due would be lower as of the later date.
5Although “step-up” is commonly interpreted to mean an increase in the value of an asset, it
technically refers to moving up the point in time, or date, at which the value of an asset is
established. In fact, for an asset that has decreased in value since the decedent purchased it,
such as an automobile, or stocks or real estate after a decline the market, the stepped-up basis
can be lower than the original cost. As a consequence of the step-up in basis rule, the loss in
value during the decedent’s period of ownership cannot be claimed as a capital loss when an
inherited asset is sold.

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Instead, when the son sold the stock after his father’s death for $1,100, he owed
a capital gains tax of $20. The $20 is equal to a 20% tax on the son’s $100 in capital
gains subsequent to the time of the father’s death ($1,100 - $1,000 = $100).6 (See
“Inherited Asset” in the middle column of Table 1.) The $180 in capital gains tax that
would have been owed on the increase in value from $100 to $1,000 during the
father’s period of ownership is forgiven. These capital gains tax rules apply under the
income tax, whether or not the father’s estate was large enough to be subject to the
estate tax.
Table 1. Capital Gains Tax Due at Sale on Inherited Asset with
Stepped-up Basis vs. Gifted Asset with Carryover Basis
Sale by Original
Inherited
Gifted Asset
Owner Before
Asset
Death
Sales price in 2000
$1,100
$1,100
Sales price in 1999
$1,000
Cost basis:
Stepped up basis in 1999
1,000
Carryover basis from 1980
100
100
Capital gain
900
100
1,000
(sales price - cost basis)
Capital gains tax rate
20%
20%
20%
Capital gains tax
180
20
200
(.20 x capital gain)
Source: Author’s assumptions and calculations.
Carryover Basis for Gifted Assets
In contrast to an asset transferred at death, an asset transferred to another person
by gift, during the giver’s lifetime (inter vivos), retains a “carryover basis.” Under a
“carryover basis” the basis of the former owner is transferred to the new owner. As
with inherited assets, the capital gains tax liability is deferred until the recipient sells
the gifted asset. Unlike the case of inherited assets, however, at the time of sale, the
6If the son had sold the stock for $1,000, no capital gains tax would have been due ($1,000 -
$1,000 = $0).

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recipient owes a capital gains tax on the increase in value during the giver’s period of
ownership as well as during the recipient’s period of ownership.7
Numerical example of capital gains tax liability on a gifted asset
with a carryover basis. Assume the father who purchased stock for $100 in 1980
instead gave that stock to his son as a gift in 1990. Assume that the market value of
the stock had risen to $500 in 1990. Nevertheless, the father would not owe any
capital gains tax upon making the gift. Suppose again that the son sold the stock in
2000 for $1,100. If the son had records to prove that his father purchased the stock
for $100, the $100 would be the son’s “carryover basis.”8 The son would owe a
capital gains tax of $200 [20 percent of ($1,100 - $100) = $1,000]. The $200 is
equivalent to the $180 in tax (forgiven in the preceding inheritance example) on the
$900 increase in the stock’s value from the time of the father’s purchase until the time
of his death, plus the $20 tax due on the $100 increase in value since the time of the
father’s death.9 The same capital gains tax rules would apply if the son had sold the
gifted stock while his father was still alive.10 (See “Gifted Asset” in the last column
of Table 1.)
Discussion of Policy Issues
Taxing Unrealized Appreciation
A common criticism of the estate tax is that many of the assets in an estate have
already been taxed at least once under the income tax. A portion of the estate is likely
to reflect, for example, invested savings from wages, dividends, interest, business
profits, realized capital gains, and other forms of income on which the decedent paid
income taxes. An exception to this criticism, however, are the unrealized gains in the
value of appreciated assets held at the time of death. Unrealized gains have not been
subject to income tax. If the federal estate tax were repealed but the step-up in basis
of assets at death continued, the appreciation in value of capital assets during a
decedent’s lifetime could avoid both the estate tax and the income tax.
7This example assumes that the value of the asset increased during both the giver’s and
recipient’s periods of ownership.
8If the son did not have proof of the father’s original purchase costs, the basis of the gifted
asset would be set at $0 and the son would owe a capital gains tax of $220 or 20% of the
entire $1,100 in sales proceeds.
9The $500 value of the stock at the time of the gift transfer is not relevant to this tax
calculation.
10This report does not discuss the gift tax which becomes due on a current basis (not at death)
once the cumulative total of a person’s taxable gifts exceeds the lifetime exclusion amount for
the “unified estate and gift tax.” Like the estate tax, the gift tax is based on the full current
value of the asset transferred, and not just the gain in value during the donor’s period of
ownership, nor the basis. Gifts of up to $10,000 per donor, per recipient, per year do not
count against the lifetime exclusion amount and are thereby exempt from the gift tax.

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Taxation at Death or When Assets Are Sold
Another criticism of the estate tax is that the tax liability is triggered by the death
of the asset-holder rather than by the sale or liquidation of assets (hence the name
“death tax”). The estate may be forced to sell assets in order to raise the cash needed
to pay the tax. This issue is particularly important to estates dominated by a single,
large, indivisible and illiquid asset, such as a family-owned business or farm, piece of
real estate, or art masterpiece. The complaint is that the family may have to part with
its major asset, possibly at a substantial discount, in order to raise the cash needed
to pay the estate tax. (It should be noted that Section 6166 of the Internal Revenue
Code currently gives estates dominated by closely held business interests effectively
15 years to pay the estate tax due on those interests. Alternatively, some individuals
purchase insurance during their lifetime to pay the estate tax due upon their death.)
Alternative Approaches to Taxing Unrealized Capital Gains
There are two main approaches to taxing unrealized capital gains that accrue
during a decedent’s lifetime, in the absence of an estate tax. One is the approach
followed in Canada of taxing the unrealized capital gains, calculated at the time of a
person’s death, as part of the decedent’s final income tax. Like the current U.S.
estate tax, this tax liability is triggered by a person’s death. However, Canadian
income tax law provides that the tax on the “deemed disposition of property at death”
can be paid in installments over a 10-year period.
The other approach to taxing the gains unrealized by the decedent is to give the
heir a carryover basis for the inherited asset instead of a step-up in basis. Any capital
gains tax liability is thus deferred until the time that the asset is sold by the heir. It is
due as part of the heir’s income tax. This second approach is the one generally
followed in the bills described in the final section of this report.
These two possibilities are among the options to increase revenues included by
the Congressional Budget Office (CBO) in its compendium of Budget Options issued
in February 2001.11 CBO provides the Joint Committee on Taxation’s estimates of
additional revenues from both of these options, shown in Table 2 below. Unlike the
legislative proposals described in the last section of this report, these estimates assume
that the estate tax is still in place and that there is no partial step-up in basis exception
to the new carryover basis rules. Revenue estimates are provided for each fiscal year
from 2002 to 2006; for the five years 2002-2006; and for the 10 years 2002-2011.
Including accrued capital gains in the last income tax return of decedents is
projected to generate approximately $11.6 billion per year in FY2003 when first fully
phased in, then dropping gradually to $10.1 billion in 2006. The five-year revenue
gain is estimated at $43.4 billion, and the 10-year revenue gain at $86.4 billion.12
Enacting a carryover basis for capital gains held until death is estimated to generate
revenues of $1.2 billion in 2003, rising gradually each year to $4.7 billion in 2006.
11U.S. Congressional Budget Office. Budget Options. Washington, February 2001.
Available on the Internet at [http://www.cbo.gov]. REV-28-A, p. 421 and REV-28-B, p. 422.
12CBO, Budget Options, February 2001, REV-28-A, p. 421.

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The five-year revenue gain is estimated at $11.5 billion, and the 10-year revenue gain
at $52.5 billion.13 The revenue gain is lower under the second option of carryover
basis for heirs because liability for the tax depends upon the heirs selling the assets.
Under the first option of including the capital gains in the last income tax return of
decedents, the tax would be due whether or not the assets were sold by the heirs.
Table 2. Estimated Revenue Gains from Including
Capital Gains in Decedent’s Last Income Tax
Return and from Enacting a Carryover Basis for
Capital Gains Held Until Death, FYs 2002-2011
($ billions)
Fiscal Year
Include Accrued
Enact Carryover
Capital Gains in
Basis for Capital
Decedent’s Last
Gains Held Until
Income Tax Return
Death
2002
a
a
2003
11.6
1.2
2004
11.1
2.2
2005
10.6
3.4
2006
10.1
4.7
2002-2006
43.4
11.5
2002-2011
86.4
52.5
a Less than $50 million.
Source: U.S. Congressional Budget Office. Budget Options. February
2001. p. 421-22. Revenue gain estimates made by the Joint
Committee on Taxation.
Replacing the Estate Tax with Full Carryover Basis for
Inherited Assets
This section compares the combined estate tax and capital gains tax liability
under current law with an alternative system that would repeal the estate tax and
instead tax the capital gains “unrealized” by the decedent. Separate estimates are
made for an estate of $10 million that would be subject to estate tax under current law
(Estate A, an estate above the exclusion amount), and an estate of $1 million that
13CBO, Budget Options, February 2001, REV-28-B, p. 422.

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would not be subject to estate tax under current law as of 2006 (Estate B, an estate
below the exclusion amount). As illustrated by the numerical examples in the text and
summarized in Table 3, estates like Estate A, currently subject to the estate tax, would
face a much lower overall tax liability under an exchange of the estate tax for a capital
gains tax on inherited assets. However, for estates like Estate B that are currently
exempt from the estate tax because of the $1 million exclusion (and/or by using the
unlimited marital deduction or other deductions), repealing the estate tax in exchange
for a full carryover basis could mean an increase in tax liability relative to current law
because of the potential new capital gains tax liability for heirs.
The examples presented in this section assume a full carryover basis on all assets
transferred at death. This helps illustrate the concern being raised on behalf of smaller
estates in relation to proposals that would repeal both the estate tax and all step-up
in basis. Acknowledging this concern, the bills described in the final section of this
report would preserve a step-up in basis for some amount of assets passed along by
each decedent.
The capital gains tax liability estimated in these examples is equal to what would
be due if a capital gains tax were collected upon the death of the decedent (i.e., a tax
due with certainty, not dependent upon sale of the assets). This is equivalent to the
potential tax due on the appreciation in value of the assets during the decedent’s
period of ownership, if and when the heirs sold the assets and realized that capital
gain.
Numerical Example of Trading Off the Estate Tax for Full Carryover
Basis, for an Estate Now Liable for Estate Tax. Imagine being an heir in
2006 to an estate with a taxable value of $10 million (after deductions).14 Assume
that of that total, $5 million represents the unrealized appreciation in the value of
assets during the decedent’s lifetime.15 Then, consider being offered the choice
14In the year 2006, under current law, the applicable exclusion amount under the estate and
gift tax is scheduled to reach $1 million. Using an example from 2006 thus simplifies the
numerical comparison between a large estate of $10 million and a smaller estate of $1 million.
15Because unrealized appreciation in the value of assets is not subject to taxation, no
information is collected about it on federal estate tax returns, and hence no data are available
from the Internal Revenue Service. Some estimates have been made in an academic study
based on data from the 1998 Survey of Consumer Finances. Poterba and Weisbenner
estimated that for all estates, in the aggregate, unrealized capital gains represented about 36%
of the total value of estates measured according to their definition of “insurance-augmented
net worth.” For estates with insurance-augmented net worth of $10 million or more,
unrealized capital gains represented about 56% of the total value of the estates. For estates
in the range of $500,000 to $1 million, the figure was 34.0%. For estates in the range of $1
million to $5 million, it was 34.6%. See: Poterba, James M. and Scott Weisbenner. The
Distributional Burden of Taxing Estates and Unrealized Capital Gains at the Time of Death.
National Bureau of Economic Research, Inc. (NBER) Working Paper 7811. July 2000.
Table 8, p. 36. Available from the NBER Web site [www.nber.org].
For purposes of the simplified example in Table 3 above, this report uses 50% as the
estimate of unrealized capital gains as a percentage of the taxable value of both the $1 million
(continued...)

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between the current system of paying an estate tax at graduated rates of 37% up to
55%, or an alternative system of paying a capital gains tax of 20% on the appreciated
value of $5 million in the estate, but no estate tax.
Table 3. Tradeoff of Estate Tax for Full Carryover Basis and
Capital Gains Tax
(Current law as of 2006, with a $1 million estate tax exclusion)
Taxable status of estate
Estate A: with
Estate B: with no
estate tax liability
estate tax liability under
under current law
current law
Taxable value of estate
$10,000,000
$1,000,000
Market value of
8,000,000
800,000
appreciated assets
at death
Unrealized capital gains
5,000,000
500,000
at death
Decedent’s basis
3,000,000
300,000
Tax Regime
Current law
No estate
Current
No estate
tax but
law
tax but
full
full
carryover
carryover
basis
basis
Estate tax due
4,795,000
0
0
0
Capital gains tax due on
0
1,000,000
0
100,000
decedent’s unrealized
gain when heirs sell the
assets, at 20% tax rate
Source: Author’s assumptions and calculations.
Under current law, the tentative estate tax on $10 million, before tax credits,
would be $5,140,800. After subtracting the unified estate and gift tax credit of
$345,800 (for decedents dying in 2006 or after), the net estate tax would be
$4,795,000.16 In comparison, a capital gains tax of 20% on $5 million would be $1
15(...continued)
and $10 million estates. This may overstate the capital gains tax liability likely for the smaller
estate. According to the Poterba-Weisbenner estimates, approximately 34% of an estate of
$1 million, or $340,000 would be unrealized capital gains. At a 20% capital gains tax rate,
the tax would be $68,000, in contrast to the $100,000 shown in Table 3.
16For decedents dying in 2000 and 2001, the applicable exclusion amount is $675,000, with
(continued...)

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million.17 (In Table 3, see the last two rows, first two columns, corresponding to
Estate A.)
Your choice of tax system might differ depending on the specific terms of your
inheritance. If you were entitled to receive a fixed percentage of the estate remaining
after taxes, you would likely prefer the capital gains tax regime. However, if you
were designated to receive a particular asset, such as a certain piece of real estate, you
might be concerned with the capital gains tax that would be due on the sale of your
particular asset, but not the estate taxes that would alternatively be paid by the estate
as a whole. As a group, however, heirs of a large estate would seem better off
choosing the capital gains tax with carryover basis instead of the estate tax.
Numerical Example of Why Estates Not Liable for Estate Tax under
Current Law Could Be Worse Off under Estate Tax Repeal with Full
Carryover Basis. Proposals to accompany the repeal of the estate tax with a full
repeal of the step-up in basis – and to fully replace it with a carryover basis – face the
criticism that smaller estates could be worse off than under current law. That is
because, under current law, estates with taxable assets less than or equal to the
applicable exclusion amount ($675,000 in 2001, and $1 million in 2006 and thereafter)
are not only free from the estate tax, but the heirs are also free from capital gains
taxes on the appreciation in value during the decedent’s lifetime when they sell the
inherited assets.18
Estates smaller than the exclusion amount would not receive any estate tax
saving if the estate tax were repealed. However, if the step-up in basis were fully
repealed, the heirs would owe a capital gains tax of $100,000 on the $500,000
appreciation in value during the decedent’s lifetime.19 (In Table 3, see the last two
rows and last two columns, corresponding to Estate B.) The possibility of a capital
gains tax liability for the heirs is why the bills listed in the final section of this report
include limited step-up provisions. These step-up allowances are intended to provide
heirs protection from capital gains taxation that is equivalent to the protection
provided under current law for estates up to a certain size (i.e., estates with unrealized
capital gains of up to the amount specified in the bills) .
16(...continued)
a unified tax credit of $220,550. Credits against the federal estate tax are also permitted for
a limited amount of state death taxes and foreign death taxes. For further explanation, see
CRS Report RS20857, How to Calculate the Estate Tax, by Nonna A. Noto.
17If the appreciated value of assets represented $8 million, instead of $5 million, of the $10
million estate, a capital gains tax of 20% would equal $1.6 million.
18The estates of most decedents do not face an estate tax liability under current law, primarily
because assets of married decedents often pass to the surviving spouse, with a step-up in
basis, under the unlimited marital deduction, and/or because the remaining assets are less than
the estate tax exclusion amount of $675,000 in 2001, rising to $1 million by 2006.
19See explanation in footnote 15.

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Administrative Concerns in Establishing Basis
A previous effort to institute a carryover basis was enacted by the Tax Reform
Act of 1976.20 Its implementation was postponed by three years by the Revenue Act
of 197821 and repealed before it ever took effect by the Crude Oil Windfall Profit Tax
Act of 1980.22,23 Leading up to the repeal, practitioners pointed out the difficulties in
trying to determine the historical cost basis of an inherited asset.
Repealing the estate tax would remove the current incentive to hold down the
valuation of assets at the time of death in order to reduce estate tax liability.
Instituting a capital gains tax in place of the estate tax would instead create incentives
to overstate the carryover basis of assets, so as to reduce the eventual calculation of
capital gains.
Furthermore, permitting some assets to receive a step-up in basis while others
retain a carryover basis would introduce still more complexities into the
administration of the tax system.24
Bills to Restrict the Step-Up in Basis in Exchange
for Repealing the Estate Tax
In the Internal Revenue Code, the step-up in basis is not part of the estate tax
law, but rather is found in the portion of the Code that defines the basis of assets for
income tax purposes.25 It would thus require additional legislative language, beyond
repealing the estate tax, to replace the step-up in basis with a carryover basis for
inherited assets. Such a provision was included in H.R. 8 which passed in the second
session of the 106th Congress, but was vetoed by President Clinton on August 31,
2000. The legislative language of H.R. 8 was reintroduced as Subtitle B of the
companion bills H.R. 627 (Boehner) and S. 333 (Lugar), introduced in the 107th
Congress on February 14, 2001.

H.R. 8 (Dunn) was reintroduced in the 107th Congress, substantially amended by
the Ways and Means Committee, and passed by the House on April 4, 2001. The new
20Sec. 2005 of H.R. 10612, P.L. 94-455.
21Sec. 515 of H.R. 13511, P.L. 95-600.
22Sec. 401 of H.R. 39319, P.L. 96-223.
23See CRS Report 95-444 A, A History of Federal Estate, Gift, and Generation-Skipping
Taxes, by John R. Luckey. p. 13-14.
24For a detailed discussion of some of the complexities involved in administering a carryover
basis regime, see: AICPA (American Institute of Certified Public Accountants). Reform of
the Estate and Gift Tax System. Tax Notes, vol. 91, no. 2, April 9, 2001. p. 307-35. See
also: Tucker, Stefan F. Thoughts on Radical Estate and Gift Tax Reform. Testimony before
the Senate Finance Committee, Subcommittee on Taxation and IRS Oversight, March 15,
2001. Reprinted in Tax Notes, vol. 91, no. 1, April 2, 2001. p. 163-70.
25Internal Revenue Code. Section 1014. Basis of property acquired from a decedent.

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bill retains the previous step-up exceptions of $1.3 million for transfers to any
beneficiaries plus $3 million to a surviving spouse. For a nonresident noncitizen
decedent, the step-up is limited to $60,000 rather than $1.3 million. H.R. 8 (107th)
also makes the exclusion of $250,000 per person for the capital gain on the sale of a
principal residence available to the heir. S. 275 (Kyl) would repeal the estate tax,
retain a step-up in basis for $2.8 million in assets, and provide a carryover basis for
assets in excess of that limit.
Most other bills introduced to repeal the estate tax would retain the current step-
up in basis rules, simply by omitting any provisions to change them. The brief
descriptions which follow focus on how the bills treat the basis for inherited assets,
and provisions the bills make for the administration and implementation of the step-up
and carryover bases.

106th Congress
H.R. 8. The Estate Tax Elimination Act of 2000. H.R. 8 passed the 106th
Congress but was vetoed by President Clinton. Title I of H.R. 8 would have repealed
the step-up in basis at the time when the estate tax was fully repealed. However, to
hold taxpayers harmless relative to current law, H.R. 8 preserved a certain amount of
step-up in basis.
Specifically, H.R. 8, after an initial nine-year phase-down period from 2001 to
2009, would have repealed the estate, gift, and generation-skipping transfer taxes
entirely in 2010. At that time, the step-up in basis at death would also have been
repealed, with two exceptions. A step-up in basis would have continued to apply to
$1.3 million in transfers from a decedent to any beneficiaries. An additional $3 million
of transfers from a decedent to his or her surviving spouse also would have received
a step up in basis.26 Property in excess of these amounts would have a carryover
basis. That is, the cost basis to the heir would be the cost at which the decedent
acquired the asset. H.R. 8 provided that the executor would elect which assets
received a step-up in basis and which a carryover basis. (H.R. 8 contained several
other provisions not described here.27)
The step-up exceptions in H.R. 8 are a way to hold taxpayers harmless relative
to the amount of estate that is free from tax under current law. Under current law, in
2006 and thereafter, a decedent will be able to transfer $1 million in assets to heirs
free from estate tax, and all those assets could receive a step up in basis. Decedents
owning qualifying farms and closely held businesses can already (as of 1998) pass
along $1.3 million in assets free from estate tax. The $1.3 million step-up exception
would cover both of these exclusions. Under current law, spouses may inherit
unlimited transfers untaxed and with a step-up in basis. H.R. 8 preserved an
26These amounts would have been indexed annually for inflation after 2010, with upward
adjustments to be made only in multiples of $10,000.
27For further discussion of H.R. 8 in the 106th Congress, and the Democratic substitute
amendments offered in its place, see CRS Report RS20592, Estate Tax Legislation: A
Description of H.R. 8, The Death Tax Elimination Act of 2000, by Nonna A. Noto.

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additional step-up in basis for $3 million in assets transferred by bequest specifically
to a surviving spouse.
107th Congress
H.R. 8 (Passed by the House). The Death Tax Elimination Act of 2001.
H.R. 8 (Dunn and Tanner) was reintroduced in the 107th Congress on March 14,
2001, replaced by an amendment in the nature of a substitute by the Ways and Means
Committee on March 29, 2001, and passed by the House on April 4, 2001. H.R. 8
(107th) contains provisions related to the estate and gift tax in addition to the
provisions described below, which focus on the treatment of step-up and carryover
basis.28
H.R. 8 would gradually lower the marginal estate tax rates during a nine-year
phasedown period from 2002 through 2010. The estate and gift tax would be fully
repealed effective in 2011. At that time, the step-up in basis provisions would be
repealed and replaced with a modified carryover basis.
Title IV of the new bill retains from H.R. 8 (106th Congress) the step-up
exceptions of $1.3 million per decedent (the aggregate basis increase) for transfers
to any beneficiaries, plus $3 million for assets transferred to a surviving spouse (the
spousal property basis increase). For decedents who are non-resident non-citizens
(also known as non-resident aliens), the new bill would limit the aggregate basis
increase to $60,000 rather than $1.3 million. The dollar amounts of these three step-
up basis exceptions would be indexed for inflation after 2010. In addition, H.R. 8
would make the exclusion of $250,000 per person for the capital gain on the sale of
a principal residence available to the inheritor of the residence. Other assets would
receive a carryover basis. That is, the basis of an inherited asset would be the lesser
of the adjusted basis of the decedent or the fair market value of the property at the
date of the decedent’s death. The executor of the estate is given the responsibility of
allocating the step-up exceptions and carryover basis to individual assets.
Compared with the previous H.R. 8 passed by the 106th Congress, H.R. 8 as
passed by the House in the 107th Congress contains numerous definitions and
restrictive or explanatory provisions. These frequently address the current interplay
between the income tax and the estate tax. There are also numerous provisions
pertaining to non-resident aliens. For example, H.R. 8 provides that the step-up in
basis limit could be increased by unused built-in losses and loss carryovers for assets;
this would apply to all decedents other than non-resident aliens. Liabilities in excess
of basis (such as loans or mortgages on an asset in excess of the adjusted basis of the
asset) would be disregarded in determining whether gain is recognized on the
acquisition of property from a decedent. There are rules governing the treatment of
appreciated carryover basis property used to satisfy a pecuniary bequest. The bill
would exclude stock in certain foreign investments from receiving a step-up in basis.
The bill contains definitions for qualified spousal property and many other terms
28For further discussion of H.R. 8 in the 107th Congress, and the Democratic substitute
amendments offered in its place, see CRS Report 30912, H.R. 8: The Death Tax Elimination
Act of 2001, by Nonna A. Noto.

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referring to property. To help protect income tax revenues, the bill would establish
reporting requirements for the transfer of assets to recipients, both for large lifetime
gifts and assets passing upon death. Cash penalties would be imposed on lifetime
donors and executors for failure to provide the required information to beneficiaries
or the IRS. The bill contains anti-abuse rules related to purported gifts made under
certain conditions and transfers of assets to nonresidents.
H.R. 627 (Boehner)/ S. 333 (Lugar). Rural America Prosperity Act of
2001. Companion bills introduced February 14, 2001. Subtitle B, on Estate and Gift
Tax Relief, reintroduces the legislative language of H.R. 8 from the 106th Congress,
with the years referred to updated by one year.
H.R. 627/S. 333 would gradually phase down estate tax rates during the initial
nine year period from 2002 through 2010. After December 31, 2010, H.R. 627/S.333
would repeal the estate, gift, and generation-skipping taxes entirely. At that time, the
bill would also repeal the step-up in basis at death. Instead, property acquired from
a decedent would have a carryover basis, with two exceptions. A step-up in basis
would be retained for $1.3 million in aggregate adjusted fair market value of property
transferred to any heirs, plus $3 million for property transferred to a surviving spouse.
These excepted amounts would be indexed for inflation after 2011, in increments of
multiples of $10,000. The executor is to allocate the step-up exceptions among the
assets. Like H.R. 8 (106th), H.R. 627/S. 333 contain provisions related to the estate
and gift tax in addition to those described here.
S. 275 (Kyl). Estate Tax Elimination Act of 2001. Introduced February 7,
2001. S. 275 was described, upon introduction by its sponsor, as a bill to replace the
federal estate tax with a tax on the capital gains earned from inherited assets, due
when those assets are sold.29 S. 275 would repeal the federal estate and gift taxes
and the tax on generation-skipping transfers immediately upon enactment. S. 275
would formally establish by name in the Internal Revenue Code (IRC) a “step-up in
basis” as the general rule for determining the basis of property acquired from a
decedent. However, it would limit the aggregate fair market value of property that
could receive the step-up treatment to the decedent’s basis in the property, plus
$2,800,000.30 Additional property acquired from or passed from a decedent would
have a carryover basis.31 In essence, for estates with assets containing more than
$2.8 million in unrealized capital gains in the aggregate, S. 275 would replace the
federal estate tax (now levied on the full market value of assets at the time of the
29Floor statement by Sen. Jon Kyl on introduction of S. 275, Estate Tax Elimination Act of
2001. Congressional Record, Daily Edition, Feb. 7, 2001. p. S1131.
30The $2.8 million amount would be indexed for inflation, to be adjusted only in increments
which are a multiple of $10,000.
31Assets in excess of the step-up limit would generally be governed by the carryover basis
rules that currently apply to property acquired by gifts (IRC section 1015), with some
exceptions. S. 275 makes an exception for annuities described in IRC section 72. Gross
income in respect of a decedent is not considered carryover basis property. Capital gain
treatment is permitted for inherited artwork even though the basis for the heir may be linked
to the basis for the deceased artist by the carryover provision (IRC section 1221(a)(3)(C)
would be amended).

CRS-14
decedent’s death and due at the time of death), with a tax on capital gains (earned
from the time the decedent purchased the asset until the asset is sold by the heir, due
at the time the asset is sold).
The $2.8 million figure can be described as a “step-up allowance.” It serves to
hold smaller estates better than harmless relative to current law. The $2.8 million
figure far exceeds the total amount of assets excluded from estate and gift taxation
under current law. Section 2057 of the IRC currently provides that estates with
qualifying family-owned business interests are eligible for an estate tax deduction
(combined with exclusion) of up to $1.3 million per decedent. All other estates have
an applicable exclusion amount of $675,000 for decedents dying in 2001 (scheduled
to rise to $1 million by 2006), without regard to the types of assets held.
The bill language of S. 275 does not give specific directions as to how the step-
up in basis and carryover basis are to be administered or allocated among specific
assets. The bill does, however, contain the following three general instructions:
(1) If the aggregate fair market value of the estate exceeds the dollar limit
for the step-up in basis (the aggregate original basis plus $2.8 million), the
executor is to allocate the $2.8 million allowance among the assets.
(2) The Secretary [of the Treasury] is to prescribe the regulations needed
to carry out the intent of the new step-up provision.
(3) Every executor is required to provide the Secretary [of the Treasury]
with information on the property acquired from a decedent to which either
the step-up or carryover basis applies, in accordance with regulations to be
issued by the Secretary.