Fixing the President's 'angel of death' capital gains tax

President Obama’s new proposal to tax capital gains at death is a welcome change that would close a huge loophole, but it suffers from a fatal flaw: For some assets, it would be a record-keeping nightmare. Fortunately, there is an easy fix.

The proposal is part of a broader tax plan that Obama has released. Right now, gains on assets that are held until the owner’s death not only are untaxed at death under the income tax, they are in fact never taxed. The person who inherits an asset gets a new basis – which is supposed to represent the cost of the asset – equal to the value of the asset at the time of death.

To see how this works, suppose dad bought a stock for one dollar. By the time dad died and bequeathed the stock to his daughter, the value rose to $1,000. If dad had sold the $1,000 asset just before death, it would have generated a $999 taxable capital gain. But if the daughter inherits the asset at $1,000 and then immediately sells it, no capital gains tax is due. The tax revenue from the $999 in capital gains is lost forever.

This “basis step-up” rule causes many problems. It is unfair, loses revenue, encourages people to hold assets longer than they should, and generates numerous tax sheltering activities, where people extract funds from assets but without actually selling them. (For more information, see Len Burman’s testimony.) For all of those reasons, taxing capital gains at death makes enormous sense.

The problem is that the record-keeping involved would be enormous. Having to keep track of every asset purchase ever made would be extremely difficult. Although the problem has been largely eliminated for trading of public stock, because of broker reports, it will still affect run-of-the-mill investors and owners of businesses, whose basis changes with depreciation and every improvement, as well as those with collectible assets, or many other investment situations.

Not only would the paperwork be substantial, the requirements would effectively be imposed in retrospect. We would be telling people now that they need to have the records from several decades ago. It is not hard to see that that creates a near-impossible situation for many people. Taxes that cannot be administered are bad policy, regardless of their merits if they could be administered.

In the 1970s, basis step-up was actually set to be eliminated in favor of what is called carryover basis, where – in the example above -- the daughter, when she eventually sold the asset, would have to report the basis that the father had in the asset. Potentially, basis would have had to be tracked for several generations. The legislation was repealed before it took effect, in part because of concerns about the complex record-keeping requirements.

Rather than throwing out the baby with the bath water and letting administrative concerns kill the idea of taxing capital gains at death, policymakers should turn to a simple fix to the “records” problem that would preserve the benefits of taxing capital gains at death while making the policy administratively feasible.

Right now, taxpayers can take a “standard deduction” on their income tax, with no paperwork, or they can choose to override the standard deduction by itemizing and documenting their deductions. Likewise, we should allow taxpayers to have a “standard basis” on capital gains held until death (or possibly on all capital gains). The standard basis would serve as the tax basis unless the taxpayer can prove her costs were different. This would relieve the taxpayer of tracking records and makes it possible for her to comply with the tax and for the IRS to administer it.

Suppose, for example, the standard basis were 20 percent of current asset value. The assets are valued in the estate, so assigning a basis of 20 percent of that value creates little hassle.

Of course, this rule will miss the actual basis in most cases. For the dad and daughter, it would set the basis at $200, so that if the daughter immediately sold the asset for $1,000, there would be capital gains tax due on $800, rather than on $999. But right now, there would be no tax due, so the “standard basis” would be a big improvement. Creating a standard basis would impose “rough justice” on the taxation of capital gains at death. That is not always ideal, but it is a lot better than the current “no justice” system we have now.

The post Fixing the President’s SOTU Capital Gains Proposal appeared first on TaxVox.