ENLARGE
President Barack Obama speaks during a visit to the University of Kansas after delivering the State of the Union address.
WASHINGTON—White House officials call it “perhaps the largest single loophole in the entire individual income-tax code.”
The tax world has a more bureaucratic-sounding description for it: “stepped-up basis” on inherited assets. It essentially means that the value of an asset “steps up” to the current value when inherited, no matter what the original buyer paid for it.
Whatever its label, the tax break sits at the center of a slate of tax changes proposed by President Barack Obama last week that would raise taxes on the rich with the aim of reducing them for the middle class.
The president’s proposal is unlikely to become law because opposition among Republicans, who control Congress, is strong. But Republicans conceivably could agree to some tweaks to the tax code that could include a portion of what Mr. Obama is seeking.
Under current law, when, say, a parent dies and passes a valuable asset to a child, no capital gains tax is due on the value that accumulated during the parent’s lifetime.
To be sure, estate tax is due if the parent were rich enough. And the child has to pay capital gains tax on the asset if he or she later sells it, but the heir gets to figure that gain by starting with the value at the time of the parent’s death—not the parent’s original cost.
For example, suppose an individual leaves stock worth $500,000 to an heir. When purchased, it cost $100,000. That means $400,000 of gain currently goes untaxed, because the capital gains tax doesn’t apply on this transfer, and the law allows the heir to sell it and figure any gain based on the stock’s stepped-up basis of $500,000.
The Obama administration basically would get rid of the stepped-up basis, by imposing capital gains tax on the transfer of the asset to the heir.
The administration includes several provisions to shield the middle class in its proposal, including an exemption for $200,000 in gain per couple, in addition to $500,000 for residential real estate. It also would exempt most types of personal property, and include special protections for small businesses and family farms.
The proposals are part of a larger package the administration proposed last week that also would create or expand a range of tax breaks aimed at boosting incomes for low- and middle-income earners, including a new $500 tax credit for two-earner households, consolidating education tax plans and expanding a child-care tax credit.
Republicans in Congress generally view the package negatively, though Republican leaders, in an interview on CBS , said they were open to the child-care tax breaks.
The administration believes the stepped-up proposal is important to its overall tax plan because of the significant revenue it would generate. The Congressional Budget Office recently estimated the tax break would be worth about $644 billion to taxpayers in the coming decade.
The Obama proposal is prompting debate about who would pay more.
Administration data show the proposals on capital gains wouldn’t have a measurable effect on households below the $200,000-$300,000 income range. But those proposals also include a significant capital-gains rate increase for the top 1% of earners--such as married couples earning about $500,000—making it hard to tell the exact impact of the change on inheritances.
About 1% of the administration’s proposed capital gains changes would fall on households with income between $200,000 and $500,000, according to Treasury data. The other 99% would affect households above that amount.
The proposals would raise at total of about $210 billion.
Other government data show that the current tax break for inherited assets benefits people in the middle-income range, and even below that.
According to a study by the CBO, about 65% of the value of the current break went to the top quintile of earners in 2013. That includes two-person households making more than about $115,000 and four-person households making more than $163,000. The rest of the benefit goes to households making less than that.
About 18% went to households in the middle quintile and under—for two-person households, those with incomes below about $78,000.
An administration official noted that a large fraction of unrealized gains are currently not taxed by either the capital gains tax or the estate tax, because of the sizable estate-tax exclusion, and because of the way estate law is structured. The current proposal is intended to make sure people pay the income taxes they owe, the official said.
Conservatives raise concerns about the effect of the president’s proposal on business investment and job creation, as well as its possible impacts on people who are somewhere short of wealthy.
Some conservatives say the proposal also represents a kind of double taxation, at least for the well-to-do, because many inherited assets already are subject to the estate tax, with a top rate of 40%. The estate tax currently hits estates valued at more than about $5.4 million, up to twice that amount for married couples.
So some wealthy families could be paying both the estate tax and the capital gains tax. The administration proposes a method of reducing the combined impact, by allowing a deduction of capital gains taxes paid on the inherited assets from the overall value of the estate. But the total amount of tax likely would still go up.
For instance, the estate tax on $10 million of taxable assets under current law would be about $4 million. The new capital gains tax could be as much as 28% under the administration’s proposal, or $2.8 million. The administration’s proposal would allow subtracting the $2.8 million from the $10 million, so the estate tax would be figured on $7.2 million. The total tax could be around $5.7 million.
This isn’t the first time that some version of the tax on inherited assets has been tried. In fact, Congress has twice before adopted the change over the last 40 years.
It was included in a tax overhaul in 1976, but postponed and then repealed a few years later. Lawmakers were concerned that it would create too many paperwork headaches for heirs trying to figure out what the original owner paid for an asset.
Congress tried it again in legislation that gradually reduced the estate tax and then repealed it for one year, in 2010—a move that caused widespread confusion among estate planners and many affluent families.
For 2010, when the estate tax went away and the capital gains tax kicked in, Congress allowed taxpayers to shield as much as $1.3 million in gain from the capital gains tax.
Even so, Congress eventually backed off the idea of imposing the capital gains tax. When it finally reached a legislative deal on the estate tax at the end of 2010, it gave people a choice of paying the capital gains tax or the estate tax for that year.
Write to John D. McKinnon at john.mckinnon@wsj.com
