Improving equity is one of the top priorities of President Biden, along with upgrading our infrastructure, increasing access to higher education, and a host of other worthy yet rather costly objectives. But a precondition to achieving these laudable goals is sufficient funding, which necessarily starts with the elimination of tax rules that tip these scales of financial justice in favor of the wealthy. Of the low hanging fruit in the tax code, one particularly ripe target is the stepped up basis rule.
This rule provides that the basis of every asset that a decedent taxpayer owned is deemed the same as its current fair market value. If a person purchased a stock for $100 a share and died when the share price was $1,000 a share, the latter dollar figure is the new tax basis of such share. Such determinations are critical. Upon the sale or trade of assets, basis is the starting point for measuring these gains and losses.
If the recipient of the stock above sells it for $1,100, the realized gain would be $100 rather than $1,000, and the recipient would pay taxes on the significantly lower gain. Because most investment assets appreciate over time, the stepped up basis rule deprives the treasury of a significant amount of tax revenue. The most recent estimate puts the cost of the stepped up basis rule at half a trillion dollars over 10 years.
The origins of this rule are somewhat mysterious. It appeared first in 1918 treasury rules. A few years later, Congress folded it into the tax code. But retention of this rule has been very easy to justify. Each taxpayer does not always keep careful records of, or remember accurately, the prices of all items he or she bought. Once a taxpayer has died, the best witness to the original purchase of specific assets is no longer available.
Regardless of its justification, it is clear that the benefits of the stepped up basis rule inure disproportionately to the top 10 percent, who own nearly 70 percent of wealth in the nation, including almost 90 percent of stock and mutual fund shares, according to the Federal Reserve. It constitutes a veiled mechanism to perpetuate wealth inequality, insulating the rich from income taxes upon the disposition of assets they inherit.
Congress has made one attempt to rectify this illogical subsidy to the wealthy. In 1976, it replaced the stepped up basis rule with a carryover basis rule, under which inherited assets would have the same tax basis that the decedent had. The financial industry mounted a lobbying effort and claimed, among other things, that it would be too hard to determine the tax basis of coin and stamp collections which make up trivial portions of transferred wealth. The industry prevailed so Congress suspended the carryover tax basis rule in 1978 and repealed it in 1980.
Much has changed in the four decades since that legislative foray. Digital records and databases have made accounting of assets much easier now, greatly facilitating proper tax basis identification. Furthermore, brokerage and investment firms have been mandated to track the tax basis of all the marketable securities held by their clients since 2011.
Congress can use this information and replace the stepped up basis rule with a carryover basis rule. This would neither solve the growing deficit crisis nor eradicate the widening inequity gulf. But it would be a step in the right direction toward a welcome source of funding for infrastructure projects and access to higher education, establish a balanced tax system, and eliminate one of the most perverse tax code rules.
Richard Schmalbeck is the Simpson Thacher Bartlett Professor of Law at Duke University. Jay Soled is a professor of business and director of the Master of Taxation Program at Rutgers University. Both the authors have testified before Congress on various tax policy issues facing the nation.