The most perverse tax code rule

President Biden has made improving equity one of his administration’s top priorities – along with upgrading the nation’s infrastructure, increasing access to higher education, and a host of other worthy yet expensive objectives. But a precondition to achieving these laudable goals is adequate funding, which necessarily starts with the elimination of tax rules that tip the scales of financial justice in favor of the wealthy. Of the tax code’s low-hanging fruit, one particularly ripe target is the stepped-up basis rule.

This rule provides that, at the taxpayer’s death, the tax basis (usually the taxpayer’s original investment) of every asset that a decedent taxpayer owned is deemed equal to its current fair market value. For example, if a person purchased Google stock for $100 a share and died when the share price was $1,000 per share, the latter dollar figure is the new tax basis of such share.

Tax basis determinations are of critical importance, because upon the sale or exchange of any asset, basis is the starting point from which gains and losses are measured. Hence, in the prior example, if the recipient of the decedent’s Google stock subsequently sells it for $1,100, the recognized gain would be $100 (i.e., $1,100 – $1,000) rather than $1,000 (i.e., $1,100 – $100) 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 a staggering half trillion dollars over a ten year scoring period.

The origins of this rule are a bit mysterious. It appeared first, without explanation, in 1918 Treasury regulations. In 1921, Congress incorporated it into the tax code, also without any meaningful explanation. But retention of this rule has been easy to justify. Taxpayers do not always keep careful records of, or remember accurately, the prices of items they bought. And once the taxpayer has died, the best witness to the original purchase of an asset 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 the nation’s wealth, including 88 percent of equities and mutual fund shares, according to the Federal Reserve. The stepped-up basis rule thus constitutes a cloaked mechanism to help perpetuate wealth inequality, insulating the well-heeled from income tax exposure upon the disposition of assets they inherit.

Congress has made one attempt to rectify this ill-conceived and 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 (in the prior example, the recipient of the Google stock would retain its original $100 cost basis). But the financial and banking industries mounted an intense lobbying effort, claiming, among other things, that it would be too difficult to determine the tax basis of coin and stamp collections which then, as now, made up a trivial portion of transmitted wealth. But the lobbyists prevailed, and Congress suspended the carryover tax basis rule in 1978 and retroactively repealed it in 1980.

Much has changed in the four decades since that legislative foray. Digital records and databases have made record keeping and bookkeeping far easier, greatly facilitating proper tax basis identification. Since 2011, brokerage and investment firms have been required to track the tax basis of all the marketable securities held by their clients.

Congress should capitalize upon this information improvement, and immediately replace the stepped-up basis rule with a carryover basis rule. Doing so would neither solve the nation’s burgeoning deficit crisis nor eradicate the widening inequity gulf. But it would be a step in the right direction to provide a welcome source of funding for infrastructure projects and access to higher education, establish a more balanced and equitable tax system, and eliminate one of the tax code’s most perverse 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.