Question 24: What is a Step-Up in Basis?

Your tax “basis” in an asset is typically what you paid for it. When you inherit assets, such as securities or property, they are stepped up in basis. That means the assets are valued at the amount they are worth when your benefactor dies, or as of the date on which his or her estate is valued, and not on the date the assets were purchased. That new valuation becomes your cost basis.

Why Does a Step-Up in Basis Matter?

In most cases, when an asset is passed on to a beneficiary, its value is more than what it was when the original owner acquired it. The asset therefore receives a step-up in basis so that the beneficiary’s capital gains tax is minimized – because it is not based on the increase in value from the original purchase price.

For example, if your father bought 200 shares of stock for $40 a share in 1965, and you inherited them in 2017 when they were selling for $95 a share, they would have been valued at $95 a share. If you had sold them for $95 a share, your cost basis would have been $95, not the $40 your father paid for them originally. You would not have had a capital gain and would have owed no tax on the amount you received in the sale. If you bought the stock for $40 and it was worth $10 at the time of your death, it would be a step-down in basis. If you sell the asset for more than your basis, you have a taxable gain. Conversely, if you sell an asset for less than your basis, typically you have a tax loss.

In contrast, if your father, during his life, had given you the same stocks as a gift, your basis would have been $40 a share. So if you sold at $95 a share, you would have had a taxable capital gain of $55 a share (minus commissions).

As you can see, the basis of the recipient of the asset may vary dramatically whether the asset is gifted during the donor’s lifetime or at death. Typically, it is best to gift assets which have a basis near fair market value while retaining assets that have a large built in gain.

What Assets Qualify For a Step-Up in Basis?

Certain assets are allowed by tax law to have their original or existing basis to be adjusted upwards to the value at the date of death. Many assets, including real estate, mutual funds, and stocks not in a qualified plan, get this step-up at the date of death. Annuities, 401(k)’s and other tax deferred qualified plans do not have such allowance. Therefore, the beneficiaries must pay tax on the asset as ordinary income.

Let’s assume that you have a $100,000 IRA and a home you bought for $25,000 in 1965 that is currently appraised at $100,000. You leave these assets to your two daughters. Sue gets the IRA and Jane gets the house. Since the IRA does not qualify for a step-up in basis, Sue will have to pay taxes on the $100,000 as ordinary income. Thus her $100,000 will be reduced by her tax bracket. If she is in the 35 percent tax bracket, her inherited amount will total $65,000.

On the other hand, Jane sells the house immediately and receives $100,000. Since the value of the home at your death was $100,000, Jane receives a step-up in basis equaling $100,000 and owes no capital gains taxes. She is able to put the entire $100,000 in her account.

Although you meant to give equally to your daughters, by not understanding and planning for the step-up in basis, one daughter gets significantly more than the other. Even if Jane wants to make things equal, she can only give Sue $12,000 before she starts reducing her lifetime exemption and have to file special tax forms. Understanding which assets get a step-up in basis can help you avoid shortchanging your heirs.

Do My Assets Get a Step-Up in Basis if They Are in My Trust When I Die?

Your share of the assets held in the Revocable Living Trust does get a step-up or step-down in basis upon your death. There will be another step-up or step-down in basis of your spouse’s share of the Trust assets at the death of your spouse. The step-up in basis allows the person inheriting the asset to sell it without having to pay capital gains tax.

Be very careful in your choice of investments while alive. Be equally cognizant of the distributions upon death. Your estate plan should account for these differences if you wish to avoid the financial conflict that will often occur. A qualified estate planning attorney can help you make wise choices when planning your estate.

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