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To Reform Stepped-Up Basis at Death, Focus on Tax Shelter Recharge

Sept. 28, 2021, 8:00 AM

The Biden administration has proposed ending stepped-up basis at death for capital gains exceeding $1 million, a move that the entire Senate Republican Caucus opposes. On Sept. 15, the House Ways and Means Committee appeared to nod to political realities when it excluded this proposal from its draft $3.5 trillion reconciliation bill. Although ending stepped-up basis may be politically infeasible at this time, Congress could more narrowly target an indefensible feature of stepped-up basis at death—tax shelter recharge.

Stepped-up basis at death can be thought of as a statute of limitations. It permanently forgives the income tax that a deceased person would have paid on assets that appreciated during their lifetime. Proponents of basis step-up point out that it allows cash-poor heirs to keep substantially appreciated family assets, such as a family home or farm, that they otherwise might have to sell in order to pay capital gains taxes. Stepped-up basis also rewards saving in a similar way that a Roth IRA does, with the primary difference being that stepped-up basis incentivizes saving for the next generation versus for retirement.

Unfortunately, stepped-up basis does more than wipe away the decedent’s capital gains tax bill. It also forgives downward basis adjustments, such as depreciation or amortization, that the decedent benefited from during their lifetime. Normally, basis adjustments that do not reflect economic reality—for example, depreciation expenses taken on an appreciating asset—get charged back when the asset is sold, through a process called depreciation recapture. Stepped-up basis at death defeats this reckoning. For no good reason, downward basis adjustments are wiped out in the step-up process, allowing the next generation to depreciate the appreciating asset all over again.

Depreciable assets that are not actually losing value are legal tax shelters. The depreciation or amortization expenses that flow from these assets allow business owners—most famously, professional sports team owners but also real estate investors and others—to offset otherwise taxable ordinary income. Such tax shelters are not unlimited. Eventually the asset is fully depreciated, and the shelter is considered “burned out.” That is, until the asset passes on to the next generation. Because stepped-up basis at death covers downward basis adjustments, it effectively recharges these burned-out tax shelters. The more extensive a decedent’s depreciated assets, the greater the recharge at death. In short, the wealthier a person is, and therefore the more depreciable assets they can afford, the more they stand to benefit from tax shelter recharge.

Defenders of stepped-up basis at death do not mention tax shelter recharge. Many do not know about it, as the conversation has centered almost exclusively on capital gains. Those who benefit from tax shelter recharge are quiet, or actively obfuscate the phenomenon. An April 2021 report prepared by Ernst & Young for the Family Business Estate Tax Coalition states in a footnote that “Depreciation is generally ignored in examples. Its effects, however, are highlighted in the illustrative family-owned apartment property.” You wouldn’t know from reading the report, but the example family-owned property functions partially as a tax shelter.

In EY’s example, the owners received $6 million in depreciation expenses, reducing their tax bill on the income from the apartment building by approximately $2.2 million. The building was not actually decreasing in value, though. On the contrary, its value rose by $16 million, $3 million due to capital investment and the remaining $13 million due to capital gains. Stepped-up basis at death forgives not just the tax on the $13 million of capital gains but also the $6 million of depreciation expenses. Those depreciation expenses offset ordinary income, effectively serving as a $2.2 million interest-free loan from the government.

If the taxpayer were to sell the appreciated asset, the effective loan would have to be repaid through the depreciation recapture process. If, instead, the taxpayer holds the asset until death, the loan is inexplicably forgiven through tax shelter recharge.

Beneficiaries of tax shelter recharge at death prefer to focus on capital gains, and for good reason. There are no good arguments against recapturing depreciation at death. Doing so would not make tax compliance unduly burdensome. In order to benefit from depreciation or amortization, the decedent had to calculate and claim these expenses on federal tax returns, so identifying the appropriate recapture amount requires nothing more than examining those returns. To prevent the intentional loss of old records, Congress could set a penalty default rule that, in the absence of proof of basis, inherited depreciable assets will be assumed to be fully depreciated or amortized.

Unlike ending stepped-up basis at death writ large, targeting tax shelter recharge would not force the sale of intergenerational assets such as family farms. Ending tax shelter recharge would only require the estate to pay tax on the decedent’s downward basis adjustments in excess of economic reality, effectively paying back the income tax that the decedent avoided through the shelter. Those adjustments having been paid back in accordance with the existing recapture rules, the heir would receive full basis in the inherited asset, able to depreciate it just as if they had bought it for fair market value.

Although Congress is unlikely to repeal stepped-up basis at death at this time, it does not have to settle for nothing. To make progress towards the goal of a fairer tax system, Congress should target the clear villain within stepped-up basis: tax shelter recharge.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Gavin Landgraf is a J.D. candidate, Yale Law School 2023.

Bloomberg Tax Insights articles are written by experienced practitioners, academics, and policy experts discussing developments and current issues in taxation. To contribute, please contact us at TaxInsights@bloombergindustry.com.

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