One critical step for anyone building an estate plan is deciding how to distribute their assets. There are many factors to balance, from relationships with loved ones to the income and estate tax implications of passing down property and the manner in which it's done.
Basis adjustment is a tax provision that you'll want to pay special attention to, whether you're creating your estate plan or expecting to receive an inheritance.
What is step-up in basis?
According to Section 1014 of the Internal Revenue Code, if a person holds property at death, it will receive a new basis equal to the fair market value of the property at the person's date of death. In the case of appreciated assets, the rule allows people to inherit the assets, such as stocks or real estate, without inheriting the tax burden that's triggered by capital gains. This is known as a step-up in basis. In states that recognize community property laws, married couples stand to benefit greatly.
The Internal Revenue Service also grants the inheritor a long-term holding period for the asset, giving them access to the more favorable long-term capital gains tax rates as opposed to short-term rates.
How does basis step-up work?
All assets have a cost basis, which is, more or less, its purchase price. When an asset is sold, the difference between the cost basis and the sale price is a capital gain (or loss). Capital gains are subject to taxes.
When an asset is inherited rather than sold or gifted, the cost basis typically gets "stepped up" to the fair market value of the property at the date of the individual's death. From a tax standpoint, it's as if the asset was purchased at the price the investor received it, and no tax is owed on any previous unrealized gains. (Refer to IRS publication 551 for more information.)
How is step-up in cost basis calculated?
Typically, the cost basis of an asset equals the purchase price of the asset, plus or minus any adjustments. In the case of real estate, the cost basis can increase when the owner makes substantial improvements or renovations or it can decrease with depreciation. For stocks, any fees or commissions you pay increase the cost basis, but investment management fees do not.
When an inherited asset qualifies for a stepped-up basis, inheritors can adjust the cost basis to the current fair market value. Any capital gain that accrued between the original purchase date and the owner's date of death is recognized, but not realized for the beneficiary. In other words, it's included in the value of the asset, but not taxable now or when the asset is eventually sold. Any appreciation in the hands of the inheritor is taxable when sold.
However, if the executor of a person's estate files an estate tax return, they may be able to elect to use an alternate valuation date of 6 months after the date of death to value the estate. This alternate valuation date can be used only if the asset depreciates from the time of the owner's date of death, and the value as of that time would be used to calculate the adjusted basis.
Learn more about cost basis and how it's calculated in Viewpoints.
Example of step-up in cost basis
Consider a hypothetical inheritor named Angela who purchased a home in 1975 for $50,000 and passed away in 2020. Over those 45 years, the value of her home increased tenfold to $500,000. In her will, she left the home to her daughter, Mary.
Mary inherited the home and the cost basis was adjusted to the fair market value of the home on the day her mother died, which was $500,000. Two years later, she sold the home for $525,000. Her capital gain was $25,000.
Without the step-up in cost basis provision, Mary would have inherited the home with a cost basis of $50,000. By the time she sold the house, her total capital gain would have been $475,000, or the difference between her mother's purchase price ($50,000) and her sale price ($525,000).
Assuming a 15% federal capital gains tax rate and a 5% state tax rate as an example, with an annual income (excluding capital gains) of $50,000, Mary would have owed about $95,000 in capital gains tax. If Mary moved into the inherited home and it became her main residence for at least 2 years, she would have qualified for a $250,000 capital gain exclusion. However, even if she qualified for the capital gain exclusion, her tax bill would still have been about $45,000 if she did not receive the step-up.
Thanks to the step-up in basis, Mary saved $50,000 in taxes on her inheritance.1
What assets are subject to step-up in basis?
Assets that receive a step-up in basis when they pass to a beneficiary include:
- Real estate
- Individual stocks or bonds
- Mutual funds
- Art and furnishings
- Collectibles
- Some business interests
Note: Assets such as the above passing to an heir from an irrevocable trust may not be eligible for a step-up in cost basis.
What assets are not subject to step-up in basis?
Assets that do not receive a step-up in basis when they pass to a beneficiary include:
- Bank accounts
- Cash
- Certificates of deposit
- 401(k)s and other employer-sponsored retirement plans
- IRAs
- Pensions
- Annuities
When you inherit one of these assets, you retain the original owner's cost basis.
How does step-up in cost basis affect capital gains rates?
Capital gains are subject to 2 different federal tax tables, depending on how long the asset was held before it was sold.
Profits from the sale of assets held for a year or less are classified as short-term capital gains and taxed at your federal income tax rate. Profits from the sale of assets held for more than a year are long-term capital gains and taxed at a potentially lower rate, at either 0%, 15%, or 20% (collectibles can be taxed up to 28%). The rate you pay depends on your taxable income.
When you inherit an asset, however, you automatically qualify for long-term capital gains tax rates, regardless of the original owner's holding period.
How does step-up in basis work in community property states?
Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin are community property states. Spouses have equal ownership of most income, assets, and debts acquired during their marriage. In a separate property state, also known as a common law property state, spouses do not have equal claim over income or property that is acquired or earned solely in their partner's name.
When one spouse dies in a community property state, the living spouse receives a significant tax benefit: A full step-up in basis on both ownership portions of all jointly owned assets. By contrast, a living spouse in a common law property state would only get a step-up in basis on the deceased partner's portion of ownership, assuming they are the beneficiary.
For example, a couple purchased a home in California, a community property state, for $500,000. Ten years later, when the home is worth $600,000, one spouse dies. The surviving spouse's new cost basis in the property is $600,000, wiping out any taxable gain up to that point. What's more, the property—if still owned by the surviving spouse upon their own death—can get another step-up in basis when it passes to the next beneficiary.
Note: Some states allow community property trusts, which essentially let married couples opt in to community property treatment. These states are Alaska, Florida, Kentucky, South Dakota, and Tennessee.
Is step-up in cost basis a tax loophole?
Step-up in basis is a feature of the US tax code. It eliminates the potential of double taxation on a deceased person's assets—while the estate may owe taxes, the inheritor does not.
Some argue that the step-up in basis rule primarily benefits wealthy households, who are more likely to own capital assets and pass them on to heirs.
Note: In his latest budget proposal, President Biden proposed eliminating the step-up in basis for capital gains greater than $5 million for single tax filers or $10 million for married tax filers.
How can I use step-up in basis in estate planning?
You can minimize taxes for your heirs by utilizing the step-up in basis provision throughout your estate plan. Here are several ways to incorporate it:
- Gift mindfully: There's a lot to consider when deciding whether to gift assets during your life or after you've passed. Gifts of appreciated stock or real estate while the owner is still living typically retain the owner's cost basis. If instead the asset is transferred upon the owner's death, it gets a step-up in basis and the recipient is never taxed on the capital gain accrued during the original ownership period. For example, if your grandchildren inherit your stock portfolio, they will receive it at the fair market value on the date of your death. If you gift it to them while you're still living, they will assume your cost basis and potentially be subject to a much larger capital gain, and subsequent tax bill, when they sell the asset. For 2024, you can gift up to $18,000 to as many people as you like, and if you're married, each person in the couple can gift this amount without the gift being considered taxable.
- Bequeath highly appreciated assets: The more an asset has appreciated, the greater the capital gain. Consider giving stocks or real estate that have appreciated significantly to your beneficiaries via your will, rather than selling them and pocketing the proceeds while you're living. This way you avoid realizing a large capital gain, which could result in an unnecessary tax bill.
- Weigh capital gains taxes now vs. a step-up later: From an estate planning perspective, it can also be helpful to consider if it's more tax-efficient to gift a low-basis asset now to a beneficiary in a lower tax bracket and pay the capital gains, or retain the asset and any future appreciation and have it included in a donor's estate for estate tax purposes. At 40%, the federal estate tax rate is significantly higher than the capital gains rate. But, if the estate won't be taxable, it could make more sense to retain the asset and receive the step-up. Another related planning option is using highly appreciated assets rather than cash to fulfill philanthropic goals. The charity will not pay capital gains taxes when it disposes of the donated asset. Within certain limits, the donor will receive an immediate income tax deduction and the asset and any future appreciation will be removed from their estate.
The benefit of step-up in cost basis
Step-up in basis is often referred to as a tax loophole because of the huge advantage it offers people who inherit assets. However, the provision is codified in the Internal Revenue Code, §1014. Basis of Property Acquired from a Decedent. By understanding how it applies to your situation you can consider alternatives, such as gifting, to help build your estate plan. Remember, everyone's tax situation is different and you should consider working with a tax advisor and a financial professional to understand what may work for you.
