Democrats Seek Backup Plan on Taxing Capital Gains

Democrats Seek Backup Plan on Taxing Capital Gains

12:47 - Alternative sought after President Biden’s proposal to limit the tax-free step-up basis runs into opposition

Entrenched opposition from some Democrats to a White House plan to tax unrealized capital gains at death has pushed the party to look for alternative methods of collecting additional taxes from wealthy Americans’ appreciating assets.

President Biden put forward a proposal to tax unrealized capital gains—including the appreciated values of homes, business, and stocks in taxable accounts—when the original owner dies, a break from current policy. Under the current tax rule known as the tax-free step-up in basis, someone who dies doesn’t have to pay any taxes on those increases, and the heirs have to pay taxes only when they sell and only on gains that occur after the original owner’s death.

The White House proposal, which included a $1 million per-person exemption and special deferral rules for family-owned farms and businesses, drew criticism from some Democrats who raised concerns about its possible impact on family farms. The House Ways and Means Committee this week didn’t propose any changes to the stepped-up basis as part of its roughly $2 trillion package of tax increases, instead opting for only a rate increase.

But some Democrats in the Senate say they are still pushing for structural changes to how capital-gains taxes are assessed, arguing that it’s the only way to close a hole that lets wealthy people escape income taxes if they own appreciating assets and never sell.

“Addressing stepped-up basis is the lowest hanging fruit on the tree,” said Sen. Elizabeth Warren (D., Mass.), who has proposed an annual tax on the net worth of households above $50 million. “What is the argument for maintaining a tax dodge that helps billionaires and that the overwhelming majority of American families never come anywhere close to taking advantage of?”

One option Democrats are now discussing is to eliminate the stepped-up basis—but not to tax capital gains at death. That would mean that heirs still only pay taxes when they sell an appreciated asset like a stock, but they would have to pay taxes on the full amount of the gain made since the original owner acquired it.

Some Democrats see that possibility, called a carry-over basis, as a middle ground between the status quo and Mr. Biden’s plan. Congress enacted a carry-over-basis rule in 1976 but repealed it before it could take effect.

“I’ve been more intrigued with the carry-over basis concept because it does seem there’s actually a realization event you capture, but I think it’s just one of a litany of ideas that we are going to have to work through,” Sen. Mark Warner (D., Va.).

Another proposal is to tax billionaires’ unrealized gains every year. The Senate Finance Committee circulated a list of possible revenue options earlier this month, listing a mark-to-market proposal that would require billionaires to pay capital-gains taxes every year as their assets appreciate, even if they don’t sell.

“A priority for me in these negotiations is making it clear that billionaires are not exempt from the general proposition [that] nurses and firefighters see every year: that they have to pay taxes regularly,” said Sen. Ron Wyden (D., Ore.), the chairman of the Senate Finance Committee.

Democrats are using a process called budget reconciliation that would allow them to pass their social welfare, tax and climate package with a simple majority, rather than the 60 votes required for most bills in the Senate. Still, with very narrow control of both chambers, they can’t lose a single vote in the 50-50 Senate and no more than three votes in the House.

Republicans have called the bill wasteful and have rejected the proposed tax increases, and none are expected to support the Democratic proposal.

Democrats are hoping to raise enough in taxes and find enough new government savings to cover the full cost of their $3.5 trillion bill, which aims to fund initiatives on healthcare and education and reduce carbon emissions. Moving to a carry-over basis could help Democrats generate more money to finance their priorities, though possibly not as quickly as taxing unrealized gains at death would.

“The big benefit that taxing at death has over carry-over basis is that more of the revenue comes within the 10 years of the window,” said Ben Ritz, the director of the Progressive Policy Institute’s Center for Funding America’s Future, referencing the 10-year timeline used for tabulating the cost of policy changes.

While the House Ways and Means Committee’s plan didn’t change how unrealized gains are taxed at death, it did propose increasing the top long-term capital-gains rate to 25% from 20%. Combined with an existing 3.8% investment income tax and a proposed 3-percentage-point surtax on people making more than $5 million, the new top rate on capital gains could be as high as 31.8%.

Rep. Bill Pascrell (D., N.J.), a member of the Ways and Means Committee, said that he would push to amend the House proposal to include a repeal of the tax-free stepped-up basis.

“Stepped-up basis may be the single worst loophole in the entire federal tax code. For weeks, armies of well-paid lobbyists have descended upon us telling lies about this loophole,” he said.

Eliminating the stepped-up basis could empower Democrats to pursue an even higher long-term capital-gains rate. Without changes to how unrealized gains are taxed at death, raising the capital-gains rate could push people to hold on to assets, rather than sell them, and reduce the amount of revenue the tax generates. Mr. Biden originally proposed raising the top capital-gains rate to 43.4%.

“I don’t think that the Ways and Means proposal is the end of the story for taxing gains at death or eliminating step up,” said Kyle Pomerleau, a senior fellow at the American Enterprise Institute. “There’s still a few things they could do to get the rate up to where they want it to be.”

The efforts could still face the same difficulties with moderate Democrats and business groups that Mr. Biden’s original plan to tax unrealized gains at death did. Not only may farm state Democrats take issue with any changes to the stepped-up basis, but Democrats may not want to raise more taxes than is necessary to cover the cost of the bill’s spending. Some moderate Democrats, including Sen. Joe Manchin (D., W.Va.), are calling on the party to dramatically shrink the $3.5 trillion proposal.

“I keep listening to Senator Manchin say he’s not going to vote for $3.5 trillion, so what’s he going to vote for? Because I don’t want to be raising money for the sake of raising money,” Sen. Bob Menendez (D., N.J.) said.

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