What US capital gains tax reform means for investors

What US capital gains tax reform means for investors

President Obama has put forth a new proposal to eliminate the “step-up” basis on inherited assets and subject more of their capital gains to taxation. What does this proposal mean for everyday investors and the economy at large?

When Donald Sterling, the embattled owner of the Los Angeles Clippers, was forced to sell his National Basketball Association franchise in the wake of racist comments, many wondered how this could be considered “punishment.” After all, the final sale price of the franchise came in at almost $2 billion, a significant mark-up from the original $12.5 million he paid for the team in 1981 . Nevertheless, Sterling bitterly fought the league’s efforts to force the sale, and his opposition stemmed not just from reasons of personal pride.

Had Sterling, who turned 80 last year, held on to the team until his death, the franchise would have been passed onto his heirs on a so-called “step-up basis.” In other words, while Sterling had to pay approximately $400 million in capital gains tax (a 20% rate on almost the entire value of the asset) because he sold the team while still alive, his heirs would have inherited the team with an adjusted step-up basis reflecting the value of the asset at the time of his death.

Had the heirs then turned around and sold the team in several years, they would only have to pay capital gains tax on any subsequent appreciation in the team’s value. If the value remained constant or declined, the capital gains tax for the heirs would be zero – or a savings of $400 million to the Sterling family.

The Sterling saga is an extreme example but it reflects the logic behind the Obama Administration’s new initiative, first unveiled in the lead-up to last week’s State of the Union address, to eliminate the step-up basis for high income taxpayers and instead treat a bequest of an asset to an heir in the same manner as if the asset were sold. The estate of the deceased taxpayer would pay out the requisite capital gains tax incurred on the appreciation in value of the asset before it is conveyed to an heir.The heir would then assume a stepped-up basis for the asset, consistent with routine sales and exchanges.

Because the Administration is at great pains to emphasize that this change would only affect high-income taxpayers, it proposes that each individual be allowed to bequeath assets with the first $250,000 of capital gains conveyed on a tax-free basis – or $500,000 for married couples. (It is unclear if the heirs could still assume a stepped-up basis on these assets.) Moreover, principal residences up to a certain value would be exempted from this new rule, as would personal heirlooms.

The prospects for this proposed reform of a fundamental feature of the U.S. tax code are iffy at best, as discussed below. Nevertheless, there are various implications of this capital gains tax reform for investors and other market participants, included below:

Greater mobility of capital encouraged

Skeptics of a capital gains tax have long argued that the levy discourages a more efficient allocation of capital for productive purposes, because the tax can be deferred so long as an asset is held and not sold. Elimination of the step-up basis will discourage tax considerations from influencing a decision on whether to retain or sell an asset. A business owner will hold or sell an asset based on strictly economic considerations; he will have no incentive to hoard the asset so that his heirs can evade most, if not all, of the capital gains tax.

Elimination of the step-up basis for inherited assets will remove an artificial tax consideration and hence promote a more productive distribution of assets to those sectors of the economy that require capital.

A first step toward greater fairness in the tax code

The Administration is touting this reform, along with other tax proposals, as an essential element to making the tax code fairer and more equitable toward the middle class. Upper-income taxpayers are most likely to realize the benefits of step-up basis, because they predominantly own assets that are subject to capital gains taxes.

It is unlikely that this proposal will be seriously debated over the next two years, as the Republican-dominated Congress has already declared the entire package DOA. Tax reform prospects, if they are to be realized, will likely focus on a more narrow corporate tax reform. However, the White House likely anticipated this development and probably put forward this proposal to influence the emerging 2016 presidential race. Whoever succeeds President Obama will likely seek fundamental tax reform as one of the first acts of his or her presidency. Challenging the long-held assumption that assets should enjoy a step-up basis when provided to heirs will likely be a welcome contribution to the debate.

Categories: Finance, North America

About Author

Jofi Joseph

Jofi is an experienced national security professional who has served in senior level positions on Capitol Hill and in the Executive Branch, with a particular focus on WMD proliferation and homeland security issues. He worked on U.S. policy toward Iran’s nuclear program and participated in P5+1 negotiations with Iran as a White House National Security Council staffer from 2011 to 2013.