You may know all about your current tax obligations, but what about the ones that go into effect when you’re no longer here? To ensure your heirs don’t get hit hard by large tax bills, you need to know the different estate planning strategies available to you.
Here, we break down the step up in basis rule, a common strategy investors use to minimize their inheritors’ capital gains tax liability.
What Is the Step Up in Basis Rule?
To understand a step up in basis, it’s important to know about cost basis — the amount paid for an investment. The cost basis is often equal to the actual purchase price, but it may increase in the case of certain events (also known as an adjusted cost basis). When you go to sell an asset, the cost basis is then used to determine whether you realized a capital gain or loss. If the sale price is higher than the cost basis, you realized a capital gain, and you’ll owe capital gains taxes.
When an asset is passed on after death, the cost basis is adjusted to reflect the asset’s value. For example, if John purchased a share of stock worth $20 (the original cost basis) and then passes away when the stock price is $40, his beneficiary’s stepped-up cost basis would be $40. If John had sold that share, he would’ve had to pay capital gains taxes on the $20 gain.
If the beneficiary goes on to sell the inherited asset for $40, there would be zero gain on the sale, and the beneficiary wouldn’t owe capital gains tax. However, let’s say they choose to sell when the value is $70. Their capital gains tax obligation is determined by the sale price minus the $40 stepped-up basis ($70 – $40 = $30 gain).
How Does It Impact Your Beneficiaries?
Without the step up in basis rule, beneficiaries may be subject to a considerably higher tax rate when they choose to sell their inherited assets. Using the example above, if the beneficiary sells their inherited share for $70 with a $40 cost basis, they owe taxes on the $30 gain. If they didn’t have a stepped-up cost basis, the beneficiary would owe capital gains tax on $50 (the sale price minus the original $20 cost basis).
Is a Step Up in Basis a Tax Loophole?
The step up in basis rule was created to help people who’ve held onto assets, such as a piece of property, for many years with significant gains. For instance, if someone had purchased a home for $100,000, and 75 years later, that home now had a fair market value of $1,000,000, the beneficiary would owe capital gains taxes on $900,000. It seemed unfair that beneficiaries had to inherit the tax liability of huge unrealized gains, so the step up in basis rule was established.
Despite the rule’s good intentions, many people feel it’s a tax loophole that favors ultra-wealthy individuals by allowing them to pass large assets to their heirs without paying taxes on the appreciation. Legislators have even proposed eliminating the rule. In 2021, President Joe Biden proposed eliminating the step up in basis for personal assets exceeding $1 million. Although the proposal didn’t receive congressional approval, many critics of the rule remain.
Lower Your Beneficiary’s Tax Liability: Tips to Follow
The step up in basis rule doesn’t seem to be going anywhere just yet, which means it can still be a strategic component of your estate plan.
Ensure your assets qualify
Many types of assets qualify for the step up in basis rule, including brokerage accounts, stocks, bonds, businesses, antiques, and so much more. There are, however, some assets that don’t qualify, such as IRAs, 401(k)s, and employer-sponsored retirement plans, whose worth can’t be readjusted to reflect an increase in value.
Don’t confuse a step up in basis for a carryover basis
If you want to transfer or gift an asset during your lifetime, the carryover basis is used to determine its tax basis. In most cases, the carryover basis is the same as the cost basis (the amount originally paid for the investment), but it may be adjusted to reflect any gift taxes that were paid. For your beneficiaries to benefit from a step up in basis, they must receive the inherited assets after you’ve passed away.
Consult with a financial advisor
The step up in basis rule can be complicated to understand and comply. Furthermore, every financial and estate plan is different, and the step up in basis rule may not always be the most advantageous strategy. It’s always best to speak with your financial advisor about how the step up in basis impacts your unique financial situation.
Would you like to know more about how you can prepare yourself (and your loved ones) for financial success? Contact us today for a personalized approach to financial planning.
