Taxation of Property at Death

Professor Jeff MaineBy Associate Dean Jeffrey Maine

The Biden administration is looking for ways to close the wealth gap and raise revenue. In addition to raising corporate taxes, the administration is also taking a close look at the taxation of property at death. Proposals being looked at include (1) increasing wealth transfer taxation on the value of property held at death, and (2) imposing income taxation on the unrealized gain lurking in property at death.

A few years ago, Congress passed the Tax Cuts and Jobs Act in December of 2017 (hereafter the TCJA). Passage produced a signal change in the wealth transfer taxes, by doubling the basic exemption amount from $5,000,000 to $10,000,000.  Since this statutory number is adjusted for inflation, in Year 2021, the exemption amount is $11,700,000 per person! This large number means that few people or their estates currently owe any transfer tax.

The doubling of the basic exemption amount in the TCJA exacerbated an already significant anomaly in the overall tax system in the United States. This anomaly is the so-called “basis step-up” rule of section 1014 of the income tax. Under the basis step-up rule, unrealized gain lurking in an asset gets wiped out at death. In other words, the unrealized gain magically disappears at one’s death and is not subject to any income tax. This is one of the biggest tax breaks in the tax code, costing the government over $40 billion a year in foregone tax revenue.

Historically an important rationale for the basis step-up rule was that its chief beneficiaries were likely to pay gratuitous transfer taxes on their wealth. Now we are in an era when only a tiny percentage of the population will owe those taxes. Thus, the capital appreciation of the assets of most of our wealthiest citizens is not subject to taxation unless the assets are sold during the taxpayer’s lifetime. Inter vivos sales may be avoidable through borrowing. This makes the income tax almost a voluntary tax for those persons. This places an inordinate tax burden on income from labor.

The TCJA’s doubling of the exemption amount highlights the modern-day incongruity of the section 1014 basis step-up rules that grant a date-of-death fair market basis to most assets that pass from a decedent. From a policy standpoint, in the absence of an effective transfer tax, a realization at death income tax regime or some other system to tax a portion of the unrealized gains inherent in those assets, the basis step-up rules should be repealed. We could adopt a carryover basis rule for bequests like we currently have for gifts. Alternatively we could treat gifts and bequests beyond some reasonable limit as taxable income to the recipient. In short, there is more than one way to address the inequities in the current system.

We will have to wait and see what, if anything, actually happens to the wealth transfer taxes and the basis step-up rule. It seems likely that we will see the lowering of the estate tax exemption to its pre-TCJA level. As for the basis step-up rule, that’s trickier. Legislation has been introduced that would tax at death unrealized gain over $1 million. But passage could be difficult.

For the time being, many planners and their clients will continue to seize the opportunity presented by the TCJA.  This means that tax planning will continue to diverge in two opposite directions. On one hand the moderately rich will seek to maximize date of death values of their estates in order to maximize the income tax basis step-up. On the other hand, the ultra-rich will follow the more traditional path of seeking to minimize value in order to reduce or avoid the gratuitous transfer taxes. It is the second path that is the main focus of my latest article Wealth Transfer Tax Planning After the Tax Cuts and Jobs Act (TCJA), which was published at 2021 B.Y.U. Law Review 1411-1487 (with Professor John A. Miller).