Step-Up In Basis At Death: What It Means For Your Estate

Have you ever wondered how tax planning could benefit you, particularly regarding an inheritance? The “Step-Up in Basis” might be the answer. It’s part of the U.S. tax code that, in simple terms, adjusts the value of an inherited asset to its value at the time of inheritance. This adjustment can lower the capital gains tax you’d have to pay if you ever decide to sell that inherited property.

The “step-up in basis” concept is a key factor when someone inherits assets like stocks, bonds, or real estate. This means that the original purchase price of the inherited asset is adjusted to its fair market value (FMV) when the previous owner passed away. By doing this, the amount of tax paid (capital gains tax) when the asset is sold could be less, as the profit from the sale may be smaller than it would have been without this adjustment.

This tax rule is essential to understand when planning an estate because it can provide significant advantages for those who are leaving the inheritance and those who are receiving it. By fully understanding how it works, both heirs and estate planners can more easily deal with the challenges of managing tax liabilities.

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What Is Step-Up In Basis At Death?

Step-up in basis is a tax provision that adjusts the value, or “cost basis,” of an inherited asset, such as stocks, bonds, or real estate, when passed on after the original owner’s death. The cost basis refers to the original price of an item before its value increases over time.

When you sell assets that have increased in value, you must pay capital gains taxes on the profit, which is the difference between the current value and the original purchase price.

When an individual inherits property, the step-up in basis rule adjusts the inherited asset’s value to conform to its fair market value (FMV) for tax purposes upon the decedent’s death. The property’s value immediately before the decedent’s death is treated as income for tax purposes. This rule is beneficial because it reduces the capital gains tax burden on the inherited property.

However, suppose the inherited asset is sold later and its value has increased since it was inherited. In that case, the new owner will need to pay taxes. But the tax will be on the increase in value from the time it was inherited, not from when it was originally purchased.

Example

For instance, imagine that your uncle gives you a house in his will that he originally bought for $100,000. By the time your uncle passes away, the house is now worth $250,000. Thanks to the step-up in basis, the original price of the house is considered to be the same as its value when your uncle died, or $250,000.

So, if you decide to sell the house at its current market price, you won’t have to pay any capital gains tax. This is because, as far as taxes are concerned, you haven’t made any profit.

What Is Capital Gains Tax?

To truly understand the advantage of a step-up in basis, it’s essential to know about capital gains tax.

Capital gain is the profit you make when you sell an asset for a higher price than you originally paid.

 Capital Gain = Selling Price – Purchase Price

The government doesn’t only tax your income; it also wants a portion of your investment profits. This is what we call the capital gains tax.

According to IRS.gov, nearly everything you own and use for personal or investment reasons is considered a capital asset. This includes things like:

• your house
• personal items like furniture
• investments such as stocks or bonds

If you sell the asset for more than what you paid (after any adjustments), you’ve made a capital gain. On the other hand, if you sell the asset for less than what you paid for it, you’ve incurred a capital loss.

For example, suppose you bought a stock for $5. In three years, you decide to sell as it’s doubled in value ($10). The difference between the purchase and selling price is $5.

Year	Stock Price	Profit
0	$5	$0
1	$5	$0
2	$5	$0
3	$10	$5

The length of time that you hold onto the asset will affect your capital gains tax rate. You will be taxed at the short-term capital gains rate when you hold an asset for less than a year. Short-term capital gains are taxed at your ordinary income tax level.

In the example above, because you’ve held on to the stock more than two years, you’d pay the long-term capital gains tax rate on the $5.

Reduced Capital Gains Tax Liability

One of the most significant impacts the step-up in basis has is on capital gains taxes at the time of inheritance, as it effectively reduces tax liability for the recipient. This is because it allows for an adjustment in the cost basis of the inherited asset to its fair market value (FMV) at the time of the decedent’s death.

When the asset is eventually sold, only the appreciation of the asset’s value from the stepped-up basis to the selling price is subject to capital gains taxes, minimizing the tax burden.

The step-up in basis can be especially beneficial for investments that have appreciated considerably over time. For example:

• A person inherits a stock portfolio with an original cost basis of $50,000
• The FMV of the portfolio at the date of the decedent’s death is $200,000
• The recipient later sells the stocks for $250,000

The taxable capital gain is calculated as follows:

Sale price: $250,000
Stepped-up basis: $200,000
Taxable capital gain: $50,000

Without the step-up in basis, the tax liability would be calculated based on the original cost basis, resulting in a higher capital gains tax.

What About Federal Estate Taxes?

One of the primary goals of the step-up in basis is to eliminate the potential for double taxation. This is achieved by focusing on federal estate taxes rather than capital gains taxes. When a person dies, their estate may be subject to estate taxes if the total value of assets, including appreciated securities and real estate, exceeds the estate tax exemption limit (In 2023, the estate tax exemption is $12 million per individual).

The step-up in basis ensures that taxes are levied at the estate level rather than at the individual level when inherited assets are ultimately sold. While beneficiaries still need to be mindful of potential capital gains taxes resulting from the eventual sale of inherited assets, the step-up in basis can provide significant tax savings, particularly for highly appreciated assets.

Is The Step-Up In Basis A Tax Loophole?

Some people see the step-up in basis rule as a tax loophole because it allows a person to transfer property that has appreciated in value to their heirs without paying taxes on the increase in value over time.

Recognizing this, the Biden administration has suggested a plan to close this loophole as part of the American Families Plan. The aim is to use the additional tax revenue to help pay for proposed improvements to infrastructure. The administration believes this tax rule primarily benefits the wealthy, particularly those with properties valued significantly over the $500,000 exemption.

If this proposal becomes law, an estate would be required to pay taxes on any increase in the property’s value. For example, if someone bought a home for $400,000 and it’s worth $1,000,000 when they pass away, the estate would need to pay capital gains tax on the $600,000 increase in value before the heir could inherit the property at the stepped-up basis of $1,000,000.

At this point, this is just a proposal from the Biden administration. It’s not yet known if it will become law in the upcoming months.

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Community Property States

Community property states have specific rules that affect the step-up in basis at death. These states treat properties acquired during the marriage as jointly owned assets.

Here are some of the special rules of community property states that impact the step-up in basis.

Community Property States Special Rules

In community property states, both spouses own the assets acquired during their marriage equally. When one spouse dies, their half of the community property receives a step-up in basis, and the share from the surviving spouse also gets a step-up in basis. This means the entire community property receives a reset cost basis in these states, resulting in potential tax savings for the surviving spouse.

According to the Internal Revenue Code (IRC) § 1014(b)(6), the step-up in basis applies to both spouses’ shares in community property. Here’s a simplified example to illustrate the process:

1. Spouse A and Spouse B purchase a house worth $200,000 during their marriage in a community property state.
2. Spouse A dies, and at the time of their death, the house is worth $300,000.
3. Both Spouse A’s and Spouse B’s shares of the house receive a step-up in basis, making the new cost basis $300,000.

When dealing with separate properties, the rules in community property states differ. Suppose the decedent’s property was not part of the community property. In that case, only their share of the property will receive a step-up in basis.

Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. 

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Estate Planning Strategies

Trusts

One common estate planning strategy involves establishing trusts. Trusts allow individuals to transfer assets into a separate legal entity managed by a trustee. For example, revocable trusts offer the flexibility of allowing for the transfer of assets while still maintaining control during the individual’s lifetime.

Upon the individual’s death, their assets held in the trust will receive a step-up basis, generally equal to the asset’s fair market value at the time of their death. This will help minimize capital gains tax when their beneficiaries eventually sell these assets.

Gift Tax Exemptions

Another estate planning tool is utilizing gift tax exemptions. The Internal Revenue Service (IRS) allows individuals to gift a certain amount of assets each year without incurring any gift tax liability. As of 2023, the annual exclusion for gift tax is $15,000 per recipient. Additionally, a lifetime gift tax exclusion of $12.06 million allows individuals to transfer larger amounts without incurring gift taxes.

It’s important to note that gifted assets will not receive a step-up in basis at death. Therefore, when selling the assets, beneficiaries will inherit the original cost basis of gifted assets, potentially incurring capital gains tax.

Considering Financial Advisors

In estate planning, consulting with a financial advisor or tax attorney may be beneficial to help navigate the complex landscape of tax laws and regulations. These professionals can guide in developing an estate plan tailored to your specific needs and financial goals. They can help you understand the implications of various strategies and ensure that your plan provides the most tax advantages for your beneficiaries.

Additional Considerations

Mutual Funds

Mutual funds and other financial assets are subject to the step-up in basis rule upon the owner’s death. When inheriting a mutual fund, the beneficiary’s basis is adjusted to the fair market value at the time of the owner’s death, which can potentially reduce capital gains tax liability in the future.

It’s crucial to maintain accurate records of the fair market value of these assets to take advantage of this step-up in basis.

Retirement Accounts

Retirement accounts such as IRAs, 401(k)s, and pensions are treated differently than other assets in the context of the step-up in basis rules. Beneficiaries of these accounts do not receive a step-up based on the inherited funds.

Instead, the distributions from these retirement accounts are generally considered income, and the beneficiaries may owe income taxes on the withdrawn funds. Factors affecting the tax implications of these accounts include the type of account, the beneficiary’s age, and the chosen distribution method.

• IRAs: When inheriting an IRA, the beneficiary may be subject to required minimum distributions (RMDs), which must be taken out and taxed.
• 401(k)s: Similar to inherited IRAs; the beneficiary may be required to take RMDs from a 401(k) and pay taxes on the withdrawn amounts.
• Pensions: In some cases, a surviving spouse may be eligible to continue receiving pension payments, which would be treated as taxable income.

Marriage and Living Trusts

Married couples may benefit from various estate planning strategies incorporating the step-up in basis rules. When one spouse dies and leaves assets to the surviving spouse, it is possible to receive a partial or full step-up in basis, depending on the state’s property rules and whether the assets are held jointly or separately. Consult with a tax professional or attorney to determine the most advantageous strategy for individual circumstances.

Additionally, the implementation of a living trust or an irrevocable trust can provide tax advantages and flexibility in estate planning. Living trusts can help avoid probate, provide for the management of assets upon incapacity, and maintain privacy.

Irrevocable trusts, on the other hand, can potentially reduce estate and gift tax liabilities by removing assets from the estate. However, irrevocable trusts generally don’t allow for a step-up in basis upon the death of the grantor.

Conclusion

In summary, the step-up in basis is a crucial tax provision that adjusts the value of an inherited asset to its fair market value at the time of inheritance. This adjustment can significantly reduce the capital gains tax burden on the recipient, as it resets the asset’s cost basis.

The step-up in basis remains an essential tax rule for inherited assets in the United States. Because of this, understanding its implications and potential changes to the rule is crucial for financial planning and wealth management.

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