The Tax Loophole (Almost) Everyone Should Want to Close

Step-up in basis for capital gains explained

James Kwak

In his latest round of tax proposals, President Obama finally called for what is probably the single most obvious change that should be made to the tax code: an end to the step-up in basis at death for capital gains taxes. (The other candidate for “single most obvious change” is eliminating the “carried interest” exemption that allows fund managers to pay capital gains tax rates on their labor income — managing people’s money.)

What is step-up in basis, you may ask? Ordinarily, if you buy something for $100 and sell it for $200 — say, a share of stock — your $100 in profit is a capital gain, which counts as a form of income, and you pay tax on it. The capital gain is calculated as your sale price of $200 minus your “cost basis” of $100. You pay tax at a lower rate than on ordinary “earned” income, like your wages, for reasons that not everyone agrees on. In addition, you also benefit from the fact that you can decide when to sell the stock, so you can defer paying capital gains tax for as long as you want, without interest — so the longer your holding period, the lower the effective annual tax rate.