By Steven M. Rosenthal and Robert McClelland
President Joe Biden and Senate Finance Committee Chair Ron Wyden (D-OR) have proposed different ways to tax unrealized capital gains every year. Their shared goal is understandable, with trillions of dollars escaping income tax under current law. But each plan raises serious administrative and legal problems.
We suggest a simpler, more effective approach: Tax unrealized gains of the wealthy at death at a higher rate than if assets are sold or given as gifts during life.
An unrealized gain is the increase in the value of an asset, like stock, which has not yet been sold. Taxing these gains is important because unrealized gains now account for more than half of the staggering amount of wealth of the very richest Americans, those with at least $100 million of net worth.
Current law encourages the wealthy to hold their assets until death, when those gains escape income tax permanently. This happens for two reasons. First, current law does not treat a bequest as a sale, so no income tax is due at death. And, second, heirs are allowed a “stepped-up basis” where they never pay tax on any increase in the value of property during a decedent’s lifetime.
The results: Government loses a massive amount of revenue, wealth inequality is perpetuated through generations, and investors are encouraged to retain (or “lock-in”) poorly balanced, and less productive, portfolios.
More than 50 years ago, two leading tax experts described the failure to tax gains of property transferred at death as “the most serious defect in our federal tax system.”
To fix this longstanding flaw, our plan would tax unrealized gains at death for the very rich (couples with more than $100 million and singles with more than $50 million) at the tax rate for ordinary income—currently 37%. But profits from sales or gifts of assets during life would still be taxed at 23.8%. Transfers to spouses would be tax-exempt. And the very rich would be allowed to deduct their income taxes at death from their estate taxes.
Our proposal turns the existing incentive for appreciated assets on its head. Instead of encouraging people to hold their appreciated assets until death to avoid income taxes, our proposal encourages them to sell these assets before they die.
For example, imagine an entrepreneur who owns $100 billion of his company stock, for which he paid nothing when he founded the firm. Under our proposal, if he holds his stock until death, he’d owe $37 billion in income tax. But if he sells during life, he would owe $23.8 billion. And if he wants to transfer his stock to his children without paying the $37 billion, he could give his stock to them during his life and pay $23.8 billion.
To determine the reach of our proposal, Rob reviewed data from the 2019 Survey of Consumer Finances , which he combined with Forbes 400 information (which is excluded from the survey). He estimated that taxpayers subject to our proposal have unrealized gains totaling about $7.5 trillion in 2022.
If these households realize $6 trillion of their $7.5 trillion of that gain during their lifetimes, and the remaining $1.5 trillion at death, our proposal would raise almost $2 trillion over time. Over the next 10 years alone, our plan could raise several hundred billion dollars, just like Biden’s and Wyden’s plan. (Our plan could raise more than theirs eventually, as our tax rate at death is higher than Biden’s and Wyden’s.)
For simplicity, we assumed the unrealized gains don’t grow over time, which likely makes our estimates conservative.
Taxing the wealthiest households on their unrealized gains at death is much easier to administer than Biden’s or Wyden’s plans to tax them annually. Our plan would rely on existing estate tax returns, and valuations, which the rich already file, while Biden’s and Wyden’s plans would impose new annual filings for taxpayers during their lifetimes. While few taxpayers would pay Biden’s or Wyden’s tax, many more would need to value all their assets annually, as taxpayers close to the line might move in and out of the regimes over time. How would the IRS determine whether all these taxpayers filed properly?
Finally, our proposal to collect taxes on transfers by gift or bequests is well -established under the U.S. Constitution , but collecting taxes outside of transfers during their lifetimes raises unresolved legal issues .
Today, older, wealthier taxpayers often hang on to appreciated assets during their lifetimes, waiting to transfer them at death . Our plan encourages them to realize gains during life, which could lead to better balanced portfolios, broaden ownership of these assets, and generate much-needed tax revenue.
Steven M. Rosenthal and Robert McClelland are senior fellows at the Tax Policy Center, a joint venture of the Urban Institute and Brookings Institution. This was first published on the TaxVox blog — “Taxing Capital Gains at Death at A Higher Rate Than During Life“.