Taxation at Death

January 22, 2015

Here’s plain talk about taxation at death, with a few words about inequality. Why? Because President Obama, in his State of the Union Address, has suggested changes to the tax code. Matt O’Brien for the Washington Post wrote President Obama Finally Has His Piketty Moment on January 17, before the speech was given. The article summarizes the Administration proposals very well.

Today I’m focused most on the stepped-up basis at death. Easy, really! Basis is the adjusted cost of property, and is a tax concept. Stepped-up basis at death means your estate’s basis equals fair market value at death, not your adjusted cost.

So, assume you bought a piece of vacant land in 2000 for $100,000. Basis equals $100,000. If you own the property for more than a year, when you sell you are taxed on the difference between net sales price and basis at the long-term capital gains rate of 15%, plus any state tax. (The rate does reach 20% with taxable income in excess of $400,000+.) With a sale in 2015 for $600,000, you will owe $75,000 in federal tax.

Fact change. Your estate—sorry, and we do miss you—sells the property for $600,000. No taxable gain for the estate, for stepped-up basis equals sales price. (I’m assuming a sale soon after your funeral.) No estate tax, either, unless your estate has a value in excess of $5,430,000. In that unlikely event—less than 1% of all estates are taxable estates—the estate tax applies, but only as to value in excess of $5,430,000. (From David Brancaccio for Marketplace on January 22, here’s A Closer Look at Inheritance Taxes, an excellent radio story about how poorly many Americans understand the whole estate tax matter.)

People—even a few of my friends—claim capital gains represent double-taxation. With vigor! They’re wrong, plain and simple! You pay tax on the difference between the net sale proceeds and your basis. For sure, that was your money working for you, but it’s the gain and only the gain on which the tax gets calculated. The money you invested is not taxed again!

Capital gains taxation, coupled with the stepped-up basis at death, leaves vast amounts of gain untaxed. No double-taxation, and lots of no-taxation!

Rationales exist for using the step-up concept, as opposed to using adjusted cost aka carryover basis. First, it’s certainly simpler to only worry about the value at death. While my example makes the basis determination easy, many asset situations include improvements, partial sales, depreciation, etc. They are more complicated, especially when years have passed.

Second, there was a time when the estate tax captured value exceeding $500,000 (1986). Fact change. Carryover basis. 1986, with an estate tax rate at 55%. Sale by your estate. The government collects tax on the $500,000 of gain, plus another $55,000 on the $100,000 of estate value in excess of the exclusion.

President Obama’s ideas are almost surely non-starters. That said, he has cleverly put forward a proposal which uses additional revenue associated with his ideas to pay for lower taxes for middle class Americans.

A civilized society requires a government, and government costs money. Our government may not work so well, but it must exist, and starving it won’t improve it.

Presently, governmental revenue comes most heavily from labor, not capital. This should surprise no one. We live with inequality as great as it was just prior to the Great Depression, and wealthy people own the capital. (Know many poor people who own office buildings or shopping centers?) Not taxing capital allows its value to grow, which increases inequality and the need for government to collect its revenue from labor, which increases inequality, etc.

I have many clients and friends who have achieved financial success. They’ve worked hard, used their brainpower and, to varying degrees, were blessed with opportunities not available to everyone. My people all acknowledge the team efforts associated with their success, and the fact that the platforms available to them here in the United States of America made their success possible. The USA was not sufficient, for sure, but it was necessary!

Nothing about what President Obama has suggested will send anyone to the poor house, or diminish in any meaningful way the factors that motivate people to produce. And the proposals may not all be the perfect solutions. Over time, however, they will tend to diminish inequality. In doing so, the pie gets larger and we all get wealthier. That should be a good thing! And if someone is offering something better I haven’t heard about it.

In closing I note that Governor Mitt Romney, Mr. 47%-er, has changed his mind. (“Romney changes his mind” is not news, I know!) Laura Clawson at Daily Kos has the goods in Romney Attacks Obama for Rising Income Inequality. And not in a Quiet Room, Either. Worth a click and 60 seconds.

P.S. I left out some details here, for sake of simplicity, and I’m not providing tax or legal advice.

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