Many clients are concerned about taxes in their estates. Some people are concerned with federal estate taxes, although those rules don’t affect too many people. Capital gains tax and the “step-up” in basis rule apply to almost everyone, and so it is important for clients to be familiar with this rule.
The “step-up” is tax rule which changes the cost basis of an inherited asset, including stocks or property, to its value as of the date of death. As a result, the beneficiary may receive a reduction in the capital gains tax they must pay on the inherited assets. For others, according to the recent article, “What Is Step-Up In Basis?” from Forbes, it allows families to avoid paying what would be a normal share in capital gains taxes by passing assets across generations. Estate planning attorneys often incorporate this into estate plans for their clients to minimize taxes and protect assets.
Here’s how it works.
If someone sells an inherited asset, a step-up in basis may protect them from higher capital gains taxes. A capital gains tax occurs when an asset is sold for more than it originally cost (subject to some other provisions we won’t worry about here). A step-up in basis considers the asset’s fair market value when it was inherited versus when it was first acquired. This means there has been a “step-up” from the original value to the current market value.
Assets held for generations and passed from original owners to heirs are never subject to capital gains taxes, if the assets are never sold. However, if the heir decides to sell the asset, any tax is assessed on the new value, meaning only the appreciation after the asset had been inherited would face capital gains tax.
For example, Michael buys 200 shares of ABC Company stock at $50 a share. Jasmine inherits the stock after Michael’s death. The stock’s price is valued at $70 a share by then. When Jasmine decides to sell the shares five years after inheriting them, the stock is valued at $90 a share.
Without the step-up in basis, Jasmine would have to pay capital gains taxes on the $40 per share difference between the price originally paid for the stock ($50) and the sale price of $90 per share.
An extremely common example of this is the primary residence. Clients who live in their home for 40 plus shares may have purchased it for $20,000, only to have it be worth $350,000 now. Absent the step-up in basis, the beneficiaries might sell the residence after mom dies and would pay capital gains tax on $330,000 worth of growth. With the step-up in basis, they would sell it for its then present value of $350,000, have a cost basis of $350,000, and therefore no gain on which to pay tax.
Other assets falling under the step-up provision include artwork, collectibles, bank accounts, businesses, stocks, bonds, investment accounts, real estate and personal property, including assets held in a revocable trust. Assets not affected by the step-up rule are retirement accounts, including 401(k)s, IRAs, pensions and most assets in irrevocable trusts. Cash also has no cost basis, and therefore no step-up.
Now, clients commonly want to make gifts of property. Giving a gift during lifetime means the original owner does not have the asset at their deaths, and so no there is step-up in basis. With gifting, the recipient retains the basis of the person who made the gift—known as “carryover basis.” Under this basis, capital gains on a gifted asset are calculated using the asset’s acquisition price.
Say Michael gave Jasmine five shares of ABC Company stock when it was priced at $75 a share. The carryover basis is $375 for all five stocks. Then Jasmine decides to sell the five shares of stock for $150 each, for $750. According to the carryover basis, Jasmine would have a taxable gain of $375 ($750 in sale proceeds subtracted by the $375 carryover basis = $375).
Taking my real estate example, mom decides to transfer the house to two of her children. She gifts them the property with her $20,000 cost basis, and when they sell the property (pre or post her death), they will be responsible for the capital gains on the $330,000 worth of growth. I have met many clients over the years who have done this on their own without the advice of an attorney, ironically on the belief they are avoiding taxes.
It is worth noting one other issue. People refer to it as the step-up because it almost typically is an increase in cost basis. Inflation makes the present value of assets much more than it was 40 years ago let’s say, but it is possible to have a step-down in basis. You see this more with stock where an individual bought and sold recently, and then passed in a down market. On the whole this rule is very taxpayer friendly, but doesn’t have to be in every case.
In summary, the step-up in basis is a powerful tool for managing capital gains tax for beneficiaries, and should be utilized in most estates.