Congress is heading into a heated debate about how much taxes should be raised to finance President Biden’s Build Back Better agenda. While pragmatic Democrats may not agree with every proposal being considered, there is one that the whole party should unite behind: closing the step-up basis loophole.
When investors sell an asset, such as a stock or bond, they are usually required to pay capital gains taxes on any increase in the asset’s value since they purchased it (the “basis”). But under current law, if the original owner dies before selling the asset, those unrealized gains are never subject to income taxes. Whenever the heir sells the asset, they are only required to pay taxes on the increase in value since they inherited it (the “stepped-up” basis).
This loophole creates an enormous incentive for wealthy individuals to buy and hold assets until death: more than half the value of estates over $100 million are comprised of unrealized capital gains that have never been subject to any income tax. And thanks to concerted Republican efforts to gut the federal estate tax, much of this unearned income is never subject to taxation of any kind. Wealthy people can also dodge taxes by using funds tied up in investments as collateral for loans, which frees up cash without triggering the capital gains tax (a tax avoidance strategy known as “buy-borrow-die”).
President Biden has proposed to shrink the step-up basis loophole by taxing unrealized gains over $1 million at death. This move would make our tax code significantly fairer and raise revenue exclusively from the wealthiest Americans to finance his agenda over the next decade. Unfortunately, some rural-state Democrats and a constellation of special interest groups have sought to undermine the proposal by framing it as “a tax plan to destroy farms and ranches.” They argue that the policy would hurt family farms and small businesses because families would have to sell those ventures off to free up cash needed to pay the tax.
It’s a familiar sob story: Republicans have used the family farm argument to argue for repealing the federal estate tax for decades, even though just 1% of estates subject to the tax include a family farm or small business. But it’s pure manure: Biden’s proposal would exempt up to $2.5 million in capital gains from a family farm or small business from ever being taxed, and taxes on gains in excess of that amount could be deferred indefinitely until the farm or business is sold outside the family.
In other words, no family farm would pay a dime in new taxes under Biden’s proposal unless it stopped being a family farm. Don’t just take my word for it: U.S. Secretary of Agriculture Tom Vilsack — a lifelong champion of farmers — wrote in a Wall Street Journal op-ed yesterday, “Keeping step-up in basis doesn’t protect farmers, it protects investors. The people who are going to pay tax under the proposal have never plowed an acre. Don’t let lobbyists use American farmers as a smoke screen to keep a system that allows the rich to pass on their wealth tax-free.”
It would be a big mistake for Democrats in Congress to further water down (as the Senate Finance Committee is considering doing) or outright reject Biden’s step-up basis proposal. Failure to close the step-up basis loophole would not only require lawmakers to find another offset to replace the lost revenue, it would also limit what they can raise from Biden’s other tax proposals. For example, the administration estimates that its proposals to equalize the top capital gains and ordinary income tax rates, combined with taxing gains at death, would raise about $330 billion over the next decade. But if step-up basis remains in tact, Biden’s steep capital gains tax hike is actually likely to lose revenue as investors choose to let more gains go unrealized and untaxed than they would under current law.
Pragmatic Democrats are right to be cautious about the impact some tax increases can have on the economy. But closing the step-up basis loophole is a straightforward and effective way to ensure the ultra-rich, particularly those who inherit rather than earn their own wealth, pay their fair share. Every dollar not raised by applying income taxes to inherited capital gains is a dollar that will be raised from other taxes more likely to discourage work or productive investment, added to our national debt, or cut from valuable public investments — all of which would be much worse for our economy.
The move could also be popular: two-thirds of respondents in a recent poll of battleground districts by the Progressive Policy Institute said that heirs should pay the same or a greater tax on money they inherit than money they earn through their own work or investments.
Democrats don’t have to agree about everything, but they should agree with this: it’s time to close the step-up basis loophole.