The stepped-up basis for our children is under attack. The Biden administration wants to either abolish the stepped-up basis altogether or alter it to generate more tax dollars. If heirs are then forced to pay a capital gains tax upon inheriting an asset, despite not selling, this could have negative consequences for families and the economy.
The stepped-up basis is a way of adjusting the tax rate paid on capital gains, which may be hiked for those who make over $1 million in combined income and capital gains. Although paying a capital gains tax rate of 39.6% + 3.8% NIIT tax may sound like a lot, eliminating the stepped-up basis would be far worse. The stepped-up basis applies to investment assets passed on after death.
When someone inherits capital assets such as real estate, stocks, bonds, or a small business, the IRS “steps up” the cost basis of these properties to the current “fair market value.” Fair market value is easier to determine for publicly traded assets. However, deciding the fair market value for real estate, private equity, or a small family business is much more subjective.
Under current tax law, when an inherited asset is sold, the inheritor only pays tax on any profits calculated from the day they inherited it. Therefore, if the asset value is stepped up to its current market value and immediately sold, the heir doesn’t have to pay any capital gains tax.
Let’s first go through an example of a stepped-up basis and then the risks of relying on the stepped-up basis to pass down assets. Then I’ll share some examples demonstrating why we need to preserve the stepped-up basis for our children. If you are an estate planner or tax lawyer, please chime in!
Example Of A Stepped-Up Asset With Stock
Let’s say Jim dies and leaves $100,000 worth of Apple stock to his son, Junior. Jim bought Apple stock years ago and his cost basis is $10,000.
The IRS resets Junior’s cost basis to $100,000 given that is what his Apple holding is worth today. Therefore, if Junior decides to sell Apple stock as soon as he gains ownership, Junior would pay zero capital gains tax. Transferring stock to Junior is the tax-efficient way to go.
If Jim had decided instead to take profits on Apple stock and sell at $100,000, he would have had to pay a 15% capital gains tax on $90,000. His tax bill would be $13,500, which would leave proceeds of $86,500.
Therefore, if Jim’s ultimate goal was to give his son his Apple stock, it would be best for Jim to hold on until death. After all, $100,000 is greater than $86,500.
Using stocks is the least contentious example for removing the stepped-up basis. Stocks don’t take work to own or operate. There is little-to-no sentimental value with stocks. And stocks can easily be sold to pay for a tax liability.
Risks Of Using The Stepped-Up Basis To Pass Down Assets
There are four risks to relying on the stepped-up basis as a means to pass down assets tax-efficiently.
1) Asset Could Decline
In the example above, transferring assets through the estate upon death is more tax efficient. However, if Apple stock had declined by greater than 13.5%, Junior would be left with less than $86,500 worth of Apple stock. Therefore, it would have been better if his father took profits when Apple was worth $100,000 and paid the tax. At least Junior still doesn’t need to pay capital gains taxes thanks to the stepped-up basis rule.
However, what if there was no stepped-up basis? Junior has to pay the $13,500 in tax and holds on. If Apple stock then proceeds to plummet, Junior’s inheritance declines even further. Let’s say Junior inherited a highly speculative asset that went to $0 after paying the capital gains tax on a $90,000 gain. Junior would actually end up losing $13,500 to the IRS thanks to his inheritance.
2) The IRS Might Disagree With Your Fair Market Value
Imagine owning a small business without a lot of close comparable sales. Without a previous sale of another business, it’s hard to value the business’s true worth. Therefore, the IRS may assign a lower fair market value to the business you inherit. That’s good for the estate. However, if you decide to sell the business one day, you would owe more in capital gains.
Therefore, it is up to the estate to try and value the small business as high as possible as long as it is under the estate tax threshold. This way, your heirs can pay a lower capital gains tax if the stepped-up basis is ever abolished.
3) You Don’t End Up Fully Utilizing Your Wealth
Another risk of relying on the stepped-up basis as a means to pass down assets is not using enough of your money to pay for a better life. If you never sell an asset, you will never incur a capital gains tax, no matter how profitable the investment is. If your estate transfers less than $11.7 million in assets to your heirs, your estate will never have to pay a death tax either.
Given only around 0.1% of estates pay a death tax (estate tax) each year, the vast majority of Americans are golden. However, the whole purpose of working, saving, and investing is to one day enjoy your wealth. Not enjoying your wealth more in order to avoid capital gains taxes is letting the tail wag the dog.
Money should be spent. Otherwise, there’s no point working and saving so much.
4) Leaving Your Kids Too Much Money
Given the median life expectancy is around 80, and the median age of new parents is around 30, the median age for people receiving an inheritance is around 50. However, leaving your middle-aged children a large inheritance is a suboptimal move.
Few 50+-year-olds need a large inheritance to survive. After 32+ years of work after high school or 28+ years of work after college, most 50+-year-olds should be self-sufficient. Your kids may lose motivation to make something of themselves. Further, your kids might feel guilty for inheriting so much.
Inheriting lots of money when someone already has money won’t be as appreciated. Therefore, it would have been better if parents spent more of their money or gave more money to their kids while they were younger.
Why We Should Preserve The Stepped-Up Basis
Imagine a 200-acre family farm in Iowa and the original owner with a low basis dies. The farm is worth $5 million and was purchased for $200,000, 60 years ago. The farm generates about $800,000 in annual operating profits. Without the stepped-up basis, the five inheritors will have to pay about $1.9 million in capital gains tax to keep the farm, if the government forces the inheritors to pay a capital gains tax.
But how are the five inheritors, who are regular middle-class farmers making $60,000 a year going to come up with $1.9 million to pay for the capital gains tax? Even divided among five people evenly, that’s $380,000 each in capital gains tax under the proposed higher rate.
Despite the farm being in the family for multiple generations, sadly, the heirs decide to sell the farm to pay for the capital gains tax. If they don’t pay the tax, the government will confiscate the land and the business. The heirs then split the $3.1 million five-ways. Their family legacy and all the sweat equity their grandparents put in are now gone forever. The buyer decided to turn the farm into strip malls.
If there was a stepped-up basis, the inheritors would receive the farm with a cost basis of $5 million. Therefore, there would be no need to pay a capital gains tax or sell the property. The heirs would be incentivized to improve the value of the farm and feed more people. Any value created after the stepped-up basis would then be taxed by the new heirs.
But as you can imagine, someone may eventually have to pay the tax, even if the farm is never sold. If the farm keeps appreciating, it may eventually push the estate over the estate tax threshold at the time. If so, the estate would pay the tax upon death of the estate owner.
How Removing The Stepped-Up Basis Hurts Potential Home Buyers
A Financial Samurai reader shares an example of how removing the stepped-up basis would decrease housing inventory. I’ve edited his example for clarity and accuracy.
I am someone who received the stepped-up basis two years ago. I’m contemplating selling one of the properties to potentially live where I want to live rather than my current home. Because of the new tax basis, selling would be feasible since I can afford the amount of capital gains tax.
Without the new stepped-up basis, selling to buy a new home where I want to live would be a non-starter. Let me explain why with an example. In 1978, parent buys a property in San Francisco, CA for $200K. The property is now valued at $3.5M.
Son wants to move to San Diego and would like to sell the property to help finance the purchase of a new home. Without the stepped-up basis, the son would incur capital gains taxes on $3.3 million in profits, or about $1.2 million in tax. The son would be left with $2.3 million before paying commission and transfer taxes. To trade a $3.5 million home for a $2.3 million home makes no sense.
Such being the case, few if any people would sell unless they absolutely had to. Instead of selling, the heir would probably rent it out and maybe finance a new home purchase, thus keeping housing inventory low and locked in for generations.
Stay long real estate, especially if the stepped-up basis gets removed.
How Removing The Stepped-Up Basis Hurts Families
Let’s say your parents die and leave you your childhood home. You grew up in it for 18 years and have been going back to visit your parents for 50 years. Your children have enjoyed visiting their grandparents for 15 years. The sentimental value of the home is enormous. Therefore, you want to keep the $3.5 million home. To you, it’s still a $200,000 home your parents bought ages ago.
You’d like to remove the popcorn ceiling, remodel the kitchen and bathrooms, install new windows, and fix all the dry rot. You have great plans to make the home great again!
Unfortunately, with the removal of the stepped-up basis, you cannot afford to pay a $1.2 million tax bill and keep the home at the same time. Even if you had $1.2 million, it would likely be tied up in investments that would incur a capital gains tax if you sold to pay your inheritance tax bill.
If all you had was $1.2 million, you would end up with 100% of your net worth in your childhood home. That’s bad net worth diversification. The stepped-up basis puts your family at financial risk if there is a economic downturn in your area.
Your only choice is to sell the home, pay the $1.2 million tax bill, and watch some other family take over your family’s home. So sad! You dreamed of growing old in your parent’s home and having your kids and your grandkids come to visit one day as well. Alas, thanks to no more step up, your dream is dashed.
Some of you might be thinking that having $2.3 million in net proceeds is enough to buy a new dream. But what good is money if you can’t buy the property and lifestyle you want? To many families, the sentimental value is priceless.
How Removing The Stepped-Up Basis Hurts Small Businesses
According to the JP Morgan Chase Institution, over 99 percent of America’s 28.7 million firms are small businesses. The vast majority (88 percent) of employer firms have fewer than 20 employees. Meanwhile, nearly 40 percent of all enterprises have under $100k in revenue.
It is clear small businesses are the backbone of the American economy. Removing the stepped-up basis hurts small business owners for taking risks and trying to provide a better life for their children. Even if the capital gains tax isn’t required to be paid immediately upon inheritance, eventually, it may have to be paid.
Imagine you are a first-generation immigrant and a minority. You come to America for the opportunity. However, due to your poor English skills and lack of connections, you can’t land a well-paying job. Therefore, you open up a bodega. For the first 20 years, you worked 16-hour days. You borrowed money from friends and family to open your first store. Over time, your store becomes a community fixture.
30 years later, you have expanded to five bodegas in your city. Each bodega generates an operating profit of $100,000 a year. You now work a more manageable 9-hour day. Your two children are managing the five bodegas, regularly working 12-hour days. They are in charge of training, inventory management, procurement, and bookkeeping.
Conflicting Cost Basis
When you pass, the IRS values your five stores at 6X operating profit, or $4 million. But what is the true cost basis of all your bodegas? It’s hard to say. Maybe the first bodega was valued at just $1,000 because you had to borrow everything to get it started. You didn’t own the land or the store. Perhaps the combined value cost basis of the five bodegas is only $500,000. Your estate fights to value the cost of all bodegas at closer to $2 million, but lose.
As a result, your two children will have to pay about $1.2 million in taxes on $3.5 million in profits. Instead of keeping your family business and legacy alive, your children have no choice but to sell a couple stores to pay for the capital gains tax bill.
Small businesses are already declining as a percent of GDP. Removing the stepped-up basis will cause more small businesses to disappear. That is no good for immigrants, minorities, those with less formal education, and entrepreneurs of all types.
Focus On Who Pays The Tax (Estate Or Heir?)
When it comes to paying the estate tax, the estate pays the tax if it is over the estate tax threshold, not the heir. By abolishing the stepped-up basis, the heir ends up paying a capital gains tax regardless of the estate tax threshold. If the estate is under the estate tax threshold, then having the heir pay a capital gains tax would defeat the purpose of having an estate tax threshold.
Currently, only if the heir receives an inheritance in a state that has an inheritance tax, will the heir pay a state inheritance tax.
But should the heir have a tax liability for receiving something he or she may never have asked to receive? Depending on the inherited asset and the heir’s own financial situation, the heir could be put in a difficult decision on what to do with the asset.
If the heir did not want the asset in the first place, the logical move would be to sell off the inherited asset to pay for the capital gains tax. This, in turn, hurts the continuity of the community and small businesses everywhere.
To then impose a capital gains tax on an heir who wants to keep the asset, but has no way to pay for a large capital gains tax bill would be a crying shame. Without the financial means to pay for the capital gains tax liability, the heir may have to sell off the asset or mortgage his future.
The government is essentially waiting for you to die or give up on your business dream in order to tax you again. That’s not very motivating to start a business, take risks, or work harder to grow a business. By removing the stepped-up basis, that is a negative signal for small business owners.
A Stepped-Up Basis Compromise: Different Rules For Different Assets
If the government really wants to alter the stepped-up basis, the government should have separate rules for types of assets.
For example, if the transferred asset is impersonal and fully fungible, such as stocks, bonds, and cash, then removing the stepped-up basis is more palatable. The heir can easily sell of the financial windfall, pay the capital gains tax bill, and still have money left over. There is no sentimental value to holding such assets.
However, if the transferred asset is an illiquid asset that can’t be easily liquidated, such as a family business, then the government should keep the stepped-up basis. The same goes for removing the stepped-up basis for an inherited family home. At the very least, the government should raise the dollar amount threshold before heirs are forced to pay a capital gains tax to cause less disruption.
If we want to promote entrepreneurship, the long-term holding of assets, and support families, we should preserved the stepped-up basis. After all, the American Families Plan is supposed to help families not hurt families.
Taking calculated risks and working hard are the two main things all of us can control. How far we get is mostly due to luck. At the very least, the government shouldn’t force heirs to pay a capital gains tax if the heirs do not sell the asset.
My Goal To Keep A Small Business Going
I plan to keep Financial Samurai going for a couple more decades as I enjoy writing. However, I’m also incentivized as a father to provide career insurance for my children.
I’m positive competition to get into good universities and land solid jobs will be even more fierce in the future. As someone with little-to-no status, I can’t use nepotism or connections to help my children find gainful employment. As a minority, perhaps my children will have less opportunities as well.
Therefore, I soldier on as a small business owner, even though I desperately want to re-retire. And if my kids are forced to sell Financial Samurai after I spent more than 32 years writing on the site, I will be pissed! Some of my family entries are priceless, especially as they age. For the new owner to turn this site into an impersonal affiliate site would be such a damn shame.
But what other choice will my kids have if they have to pay millions in taxes without the stepped-up basis upon inheritance? If they absolutely don’t love to write and free from a typical 9-5 job, would they be willing to keep FS going?
Will my kids be able to fight the temptation of selling their father’s legacy if someone offered them, say, $20 million? After all, they weren’t the ones who put in all the time and effort to create this site. Even if they had to pay a total effective tax rate of 50%, that still leaves them with $10 million.
For me, I would find paying $10 million in taxes to be an absolute economic waste. To them, they might think what’s the big deal since they’ll be $10 million richer. It wasn’t their money in the first place. Besides, they read on Financial Samurai that $10 million is the ideal net worth figure to retire!
Helping All Families Prosper
Trying to raise the capital gains tax rate to 43.4%, the top federal marginal income tax rate to 39.6%, and the corporate tax rate to 28% is already good enough. I’m most excited about the American Families Plan providing paid parental leave and subsidized childcare.
However, let’s save the stepped-up basis for the good of more American families. Small businesses owners are significant employers and vital for the American economy. Having a stepped-up basis encourages hard work.
Forcing heirs to sell off family businesses to pay an unnecessary capital gains tax is a self-inflicted wound. Even if heirs don’t have to pay the capital gains tax immediately, someone may eventually.
When it comes to families, let’s help all families thrive.
Readers, what do you think about the stepped-up basis? Why does everyone think the stepped-up basis only affects the really rich? What kind of solutions do you have for illiquid assets and small business owners if the stepped-up basis is removed?
Disclaimer: I’m not a tax attorney and don’t play on on TV. But I am a tax enthusiast. Find a tax professional or estate planning lawyer to help you with your estate planning issues.