To reform the increased base on death, focus on recharging the Tax Shelter

The Biden administration has proposed ending the beefed-up death base for capital gains greater than $ 1 million, a move opposed by the entire Republican Senate caucus. On September 15, the House Ways and Means Committee appeared to wink at political realities when it excluded this proposal from its $ 3.5 trillion reconciliation bill. While it is politically impossible to end the grossed-up base at this time, Congress could more narrowly target an indefensible feature of the grossed-up base at death: the recharge of the tax shelter.

The increased base on death can be considered a limitation period. It definitely cancels out the income tax that a deceased person would have paid on assets that have appreciated during their lifetime. Proponents of the base increase point out that it allows cash-poor heirs to keep greatly valued family assets, such as a family home or farm, which they might otherwise have to sell to pay taxes on them. capital gains. The Enhanced Base also rewards savings in the same way as a Roth IRA, the main difference being that the Enhanced Base provides incentives to save for the next generation in relation to retirement.

Unfortunately, the strengthened base does more than wipe out the deceased’s capital gains tax bill. It also waives basic downward adjustments, such as depreciation or amortization, from which the deceased has benefited during their lifetime. Normally, basic adjustments that do not reflect economic reality, such as depreciation expenses taken on an asset under appreciation, are re-invoiced when the asset is sold, through a process called depreciation recapture. The base reinforced at death goes against this calculation. For no good reason, the basic downward adjustments are erased in the acceleration process, allowing the next generation to depreciate the asset under appreciation again.

Depreciable assets that do not actually lose value are legal tax shelters. The depreciation or amortization expenses that arise from these assets allow business owners, including owners of professional sports teams, but also real estate investors and others, to offset ordinary income that is otherwise taxable. These tax shelters are not unlimited. Ultimately, the asset is fully depreciated and the shelter is considered “burnt”. That is, until the asset passes to the next generation. Since the increased base at death covers the base adjustments downward, it effectively recharges those depleted tax shelters. The greater the impaired assets of a deceased person, the greater the recharge at death. In short, the richer a person, and therefore the more depreciable assets they can afford, the more likely they are to benefit from the tax shelter recharge.

The defenders of the base increased on death do not mention the recharging of the tax shelter. Many do not know this because the conversation has been almost exclusively about capital gains. Those who benefit from the recharging of tax shelters are silent or actively mask 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 evident in the illustrative family apartment building. You wouldn’t know from reading the report, but the homestead example works in part as a tax shelter.

In the EY example, homeowners received $ 6 million in depreciation expense, reducing their building income tax bill by approximately $ 2.2 million. The building wasn’t actually diminishing in value, however. On the contrary, its value increased by $ 16 million, $ 3 million due to capital investments and the remaining $ 13 million due to capital gains. The increased base on death not only waives tax on the $ 13 million in capital gains, but also the $ 6 million in depreciation expense. These depreciation expenses offset regular income, effectively serving as the government’s $ 2.2 million interest-free loan.

If the taxpayer sold the appreciated asset, the actual loan would have to be repaid through the depreciation recovery process. If, on the contrary, the taxpayer holds the asset until his death, the loan is inexplicably canceled through the recharging of the tax shelter.

Beneficiaries of tax top-up on death prefer to focus on capital gains, and for good reason. There are no good arguments against recovering depreciation on death. This would not unduly increase tax compliance. In order to benefit from depreciation or amortization, the deceased had to calculate and report these expenses on federal income tax returns. Therefore, identifying the appropriate clawback amount requires nothing more than reviewing these statements. To avoid the intentional loss of old records, Congress could establish a default penalty rule that, in the absence of substantive evidence, inherited depreciable assets will be assumed to be fully impaired or amortized.

Unlike the abolition of the increased base on death in the broad sense, targeting the recharge of tax shelters would not require the sale of intergenerational assets such as family farms. Ending the tax shelter recharge would only require the estate to pay tax on the deceased’s basic downward adjustments beyond economic reality, effectively refunding the income tax the deceased avoided. thanks to the shelter. These adjustments having been reimbursed in accordance with the existing salvage rules, the heir would receive all of the inherited asset, capable of depreciating it as if he had purchased it at its fair market value.

While Congress is unlikely to repeal the Reinforced Base on Death at this time, it doesn’t have to settle for nothing. To move towards the goal of a fairer tax system, Congress should target the obvious villain on a stronger basis: tax shelter recharging.

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

Author Info

Gavin Landgraf is a JD candidate, Yale Law School 2023, and a captain, US Marine Corps Reserve.

Bloomberg Tax Insights articles are written by seasoned practitioners, academics, and policy experts who discuss current tax developments and issues. To contribute, please contact us at [email protected].