What's the official reasoning behind "stepped-up basis" when selling inherited property?

Question

Note: "official" here means "on-paper". Meaning: I'm not asking what's the true reason this stepped-up basis calculation exists, but rather how it's justified on paper. This is to prevent this from getting political.

I'm a non-American and was recently made aware of the "stepped-up basis" calculation when selling inherited property.

This quote (source) should explain for non-Americans:

Plus, your inheritance receives a "stepped-up basis" to the date of the decedent's death as well.

For example, you might inherit a house that's valued at $250,000 on the decedent's date of death. You then sell the property for $275,000 a few years later. You would owe long-term capital gains tax on $25,000.

Even if the decedent purchased the property decades ago for $100,000, your gain isn't calculated using this number.

Playing the advocate for this rule for the sake of trying to understand it, I couldn't come up with a convincing argument.

Answer 1

I don't think you'll find "official reasoning" from the IRS. The most reasonable explanation in my view is that it prevents double-taxation of estate assets and applies a consistent methodology for taxation of inherited property. The estate tax is based on inherited value, not the basis.

Say you inherited a $50M estate that had a $1M basis. Upon inheritance almost $38M ($50M - $11.2M exemption, and some disparity caused by progressive tax rates) would be subject to the 40% estate tax rate. If the basis wasn't stepped up and you sold it immediately for $50M you'd pay 20% of almost $49M in capital gains tax.

The exemption amount was much lower in the past, so this double-taxation issue was more relevant. In 2010 people actually had a choice between carryover basis and stepped up basis, if they chose carryover basis they paid no estate tax. That odd year highlights the link between estate tax and stepped up basis.

It is also logistically challenging to try to track basis over generations, while determining current value is relatively easy for most assets.

Of course, the high exemption amount and trust-based loopholes allow many to avoid estate tax, which erodes the impact of stepped up basis, but that's the nature of our complex tax code.

Answer 2

One intent is to reduce double-taxation. If several people inherit a property with a low cost basis (say a house that was bought decades ago), then the most practical thing is usually for some or all of them to sell it and take the proceeds. With a very low cost basis, the total value of the property is effectively what is inherited.

But in the US, there is also an estate tax that is levied on estates upon inheritance (with a very large exemption). If the value of the property were effectively inherited (via a low cost basis), AND the estate tax were to apply, then the property would be effectively taxed twice.

Now, the estate tax only kicks in in very large estates, so this particular benefit only applies to the very wealthy, but it also benefits those that inherit, say, a family farm that don't then have to pay a large tax bill upon inheriting the land.

Answer 3

I'm not sure if the IRS, or indeed the US government in general, ever really justifies anything beyond "Well, we're the ones making the rules".

However, I really don't understand why you can't come up with a convincing argument, since to me this seems the most obvious and fair way of doing things. Consider inheritance as a gift: when someone gives you a gift, you don't (unless you're really rude) ask them how much they paid for it. If you decide you don't want the gift and decide to sell it on eBay, what the giver paid for it is irrelevant: the price is what the buyer will pay for it today.

Answer 4

The US position is that tax on unrealized gains on investments, property, and the like should be imposed on the estate of the deceased, and not on the person(s) inheriting the asset(s). Thus, the inheritors get the stepped-up basis for the asset and pay tax only on the gain (difference between selling price and stepped-up basis) when the asset is disposed of by the inheritor.

Now, the executor of the estate must file an estate tax return to close out the estate when all the assets have been distributed to the beneficiaries and pay the estate tax due, and the executor must plan for this payment (as well as other costs of administering the estate, including settlement of outstanding debts, collection of outstanding loans, the executor's fee, if any). Thus, if the will of the deceased (or probate court in the absence of a will) says "I appoint the law firm of Dewey, Cheathem, and Howe as executors of my estate, and leave all my assets to my sole heir Sonny Boy" than it is not true that Sonny Boy will get all the assets of the deceased as of the date of death: he will get whatever is left after all the fees have been paid and a sum of money set aside for payment of estate tax. Some of the assets might need to be sold to pay for all this, and if so, the estate will pay capital gains tax on that sale, and Sonny Boy will have a stepped-up basis for whatever assets he actually receives as his inheritance after all fees and costs have been paid. Now, it might be claimed that actually Sonny Boy did end up paying for the estate tax (and all other fees) but it is not an out-of-pocket expense for Sonny Boy. As an additional quirk, note that IRA assets are included in the estate for estate tax purposes even though they will become Inherited IRAs for the beneficiaries designated to the IRA custodian and not in accordance of any directions that the will might provide explicitly or implicitly as in "leave all my assets to Sonny Boy". If the IRA custodian has on file an IRA beneficiary designation leaving the IRA to the deceased's niece Flora, then the IRA will pass to Flora and not to Sonny Boy.

All this is fine and dandy but the US also has a combined lifetime gift and estate tax exemption (currently $11.4M) and thus more than 99% of all estates in the US pay no estate tax whatsoever (their value is below the exemption). Thus, in most cases, what Sonny Boy will inherit is all the assets less court costs and whatever Dewey, Cheathem, and Howe will charge as their fee.