Step-Up vs. Carryover Basis for Capital Gains: Implications for Estate Tax Repeal

Publication Date: April 2001

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Banking and finance

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Abstract:

Current income tax law provides for a "step-up" in the basis of an inherited asset to its fair market value at the time of the decedent's death. When the heir sells the asset, the capital gain for income tax purposes is measured by the difference between the heir's selling price and the stepped-up basis of the asset. (The basis is no longer the asset's cost at the time when the decedent acquired it. That would be known as a "carryover" basis.) As a result, there is no income tax liability on the appreciation in the asset's value during the decedent's period of ownership (lifetime) - for the decedent as well as the heir.

If the federal estate tax were repealed but the step-up in basis of assets at death continued, the appreciation in value of capital assets during a decedent's lifetime could avoid both the estate tax and the income tax. If the estate tax were repealed but inherited assets received a carryover rather than stepped-up basis, a capital gains tax would be due on this appreciation in value when the assets were sold by the heirs.

As shown by numerical examples, estates that are subject to substantial estate tax liability under current law would face a much lower overall tax liability under an exchange of the estate tax for a capital gains tax on inherited assets. However, for estates which are not subject to estate tax liability under current law, repealing the estate tax in exchange for a carryover basis could mean an increase in income tax liability on capital gains relative to current law for heirs, unless a step-up in basis was preserved for some amount of a decedent's assets. (The estates of most decedents do not face an estate tax liability under current law, primarily because assets of married decedents often pass to the surviving spouse under the unlimited marital deduction, and/or because the remaining assets are less than the estate tax exclusion amount of $675,000 in 2001, rising to $1 million by 2006.)

Most bills to repeal the estate tax would retain the current unlimited step-up in basis. However, a few bills would institute a carryover basis for inherited assets in exchange for repealing the estate tax. H.R. 8 (as passed by 106th Congress, but vetoed by President Clinton in August 2000) would have replaced the step-up in basis with a carryover basis when the estate tax was fully repealed, with a limited amount of assets entitled to receive the step-up in basis. H.R. 8 (Dunn and Tanner) was reintroduced in the 107th Congress, substantially amended by the Ways and Means Committee, and passed by the House on April 4, 2001. The new bill retains the previous step-up exceptions of $1.3 million for transfers to any beneficiaries plus $3 million to a surviving spouse. For a nonresident alien decedent, the step-up is limited to $60,000 rather than $1.3 million. H.R. 8 (107th) also makes the exclusion of $250,000 per person for the capital gain on the sale of a principal residence available to the heir. S. 275 (Kyl) would repeal the estate tax, retain a step-up in basis for $2.8 million in assets, and provide a carryover basis for assets in excess of that limit. There are many questions about how either a carryover or step-up in basis of inherited assets could be administered in the absence of a federal estate and gift tax. This report will be updated to reflect other bills introduced in the 107th Congress to change the estate tax and the accompanying basis rules for inherited assets.