Step-Up in Basis and Why It Matters in Estate Planning

Recent news stories may have made you aware of the “step-up in basis” and the current administration’s desire to eliminate or adjust it.

If you are considering engaging in estate planning or you may be inheriting assets, it is important to understand what the step-up in basis is and how it may affect you.

What Is the Step-Up In Basis?

The step-up basis is a provision in federal tax law. It determines how assets are valued for calculating capital gains taxes when a person passes away, leaves these assets to heirs, and those assets are sold.

So, for example, imagine a person passes away and leaves their home to their children through their will.

When the children inherit the property, the home’s cost basis changes. (“Cost basis” is the amount for which an item is originally purchased.) The home’s cost basis is adjusted – or “stepped up” – from what it was valued at when the parent originally purchased the home to its fair market value on the date the parent died.

In this case, suppose the original cost of the home 30 years ago was $100,000, and the “stepped up” basis in 2022 (date of death) is $300,000.

If the children then sell the home for $500,000, the resulting capital gains liability is calculated by subtracting the stepped-up basis from the sale price. This determines the children’s taxable gain ($500,000 – $300,000 = $200,000 gain). The effect is that the capital gain between the original purchase of the home and the children’s receipt of it is eliminated.

In other words, without the step-up in basis, the children who inherited the property would have had a considerably higher taxable gain after the sale ($500,000 – $100,000 = $400,000 gain). As a result, they would then have potentially had to pay more in capital gains tax.

Why Bequeath Assets Through a Will or Estate Plan?

Passing assets, such as the home in the example above, to your loved ones through your will or estate plan means those who inherit are often subject to much lower capital gains tax than if the assets were outright transferred or given to your loved ones during your life.

This is because assets transferred or gifted before death are subject to the purchaser’s cost. Capital gains tax is then calculated based on the differential between the original cost basis and the sale price (after considering any depreciation or other capital gains exclusions that may apply).

What Assets Step Up In Basis Upon a Person’s Death?

The step-up in basis can apply to many kinds of assets, including:

• real estate
• personal property
• brokerage accounts
• stocks
• bonds
• bank accounts
• businesses
• art
• antiques
• collectibles
• and much more

Gifting or bequeath these types of assets through your will or estate rather than giving them away during your life can make a big difference for your heirs.

In addition, under federal law, all community and marital property gets a new basis when the first spouse dies. Their death brings the property up to the fair market value at that time. So, a surviving spouse could sell these assets and take advantage of this adjusted basis. And, subject to certain exceptions, the qualifying property of the surviving spouse can also receive a second step-up in basis at their death.

When Does the Stepped-Up Basis Not Apply?

While some assets qualify for a stepped-up basis, some can lose the ability to receive an adjusted basis.

For example, a surviving spouse cannot benefit from a second step-up in basis for assets that had been placed into an irrevocable trust before the first spouse’s death.

The stepped-up basis also does not apply to the following types of assets:

• IRAs
• employer-sponsored retirement plans
• 401(k)s
• pensions
• tax-deferred annuities
• gifts made before death
• and some other assets

When Are Capital Gains Taxes Assessed?

Capital gains are taxed when an asset is sold (for a profit).

In the above example, if the house is sold three years after the parent’s death for $700,000 (which would mean it increased in value by an additional $400,000 during this time), then capital gains tax is potentially due on $700,000 (sale price in 2025) – $300,000 (stepped-up basis at date of death) = $400,000 of gains.

It is assessed and payable for the tax year in which the post-death sale occurred, and liability effectively shifts to the heirs who benefit.

Why Do Some Believe the Step-Up in Basis Should Be Eliminated?

Many believe the stepped-up basis creates an inequitable tax loophole that allows people with significant assets to shelter these assets from capital gains tax if they dispose of them through their estate.

For example, in the scenario above, if the home was initially purchased for $100,000 and sold by the heirs of the purchaser for $1,000,000 shortly after the purchaser’s death, $900,000 of capital gains would effectively never be taxed.

Meanwhile, someone who sell their assets during their lifetime will likely not get equal tax benefits (even considering the $250,000 personal residence capital gains exclusion) and may face a hefty capital gains tax bill.

On the other side of this argument are those who posit that not having a stepped-up basis can lead to double taxation. From their viewpoint, heirs or an estate would face capital gains tax as well as potentially significant estate tax.

This would likely only affect those with a good amount of wealth, given the current federal estate and gift tax exclusion, which will rise from $12.06 million in 2022 to $12.92 million in 2023. Most people will not fall into this category. Because of this, the tax revenue that the government could raise by eliminating the step-up-basis could arguably outweigh the double taxation issue.

However, this could all change after 2025, when the federal exclusion is set to be cut by approximately half. This will potentially affect a much larger group of people. The argument may not be so strong under those circumstances.

Navigate Estate Planning With a Qualified Attorney

Planning to avoid capital gains taxes is a complex endeavor that a person should only undertake with the assistance of a qualified professional. Every person’s situation is different, and there is no one-size-fits-all solution.

While saving money on capital gains may seem attractive, there may be situations where leaving assets to heirs upon your death may not be the best plan or may create more significant tax issues. In addition, it may not be the best strategy if, for example, you need to engage in Medicaid planning.

Please feel free to reach out to Sowards Law Firm at (408) 371-6000 or info@SowardsLawFirm.com with any questions or concerns.