A step-up in basis can reduce capital gains tax liability on assets.
Some assets can appreciate in value or lose value while owned.
Examples include stocks and real estate.
According to a recent Forbes article titled “What Is Step-Up In Basis?,” capital gains taxes are levied on the sale of assets when the value or “cost basis” has increased.
When an asset like a family home has been held for decades, these taxes can be quite large when sold.
A step-up in basis can reduce tax liability for heirs who inherit through an estate.
How does a step-up in basis work?
When an heir inherits the property, the value of the property is adjusted to that “date of death” value.
Essentially, there is a step up from the value of the asset when it was acquired to the fair market value on the date it was inherited.
As long as assets are held without being sold, no capital gains tax must be paid.
This means the value can receive a step-up in basis over generations.
Should an inheriting heir choose to sell the inherited asset, the capital gains tax will be calculated based on any increase in value since inherited.
Only the gains from the time of inheritance will be taxed.
If the inheriting heir sells it immediately, capital gains tax may be little or nothing.
Even if the inheriting heir later sells, the capital gains tax will be far less than had the value never stepped up.
If you enjoy math word problems, consider this scenario.
Michael purchased 200 shares of ABC Company stock for $50 each.
He leaves this ABC Company stock to Jasmine at his death.
When he dies, the value of each share is $70.
Jasmine holds these shares for five years and then chooses to sell them at a value of $90 per share.
If these shares had not received a step-up in basis, Jasmine would owe capital gains taxes on $40 per share because this was the value increase between $50 and $90.
With a step-up in basis, Jasmine will only be subject to a capital gains tax of $20 per share because this was the difference between the sale value and the value at the time of inheritance.
In this case, the funds subject to capital gains would have been doubled without this step-up in basis.
Although stocks and real estate are common assets subject to capital gains taxes, other investments also qualify for step-up provisions.
These include artwork, bank accounts, businesses, bonds, collectibles, investment accounts, and personal property.
However, IRAs, 401(k)s, and pensions do not enjoy a step up.
Also, assets held in most irrevocable trusts do not.
What happens if a person gifts an asset while they are alive?
The recipient will receive the basis of the individual who made the gift.
This is considered a carryover basis as contrasted with a step-up basis.
In these gifted transfers, the capital gains are calculated on the acquisition price of the asset.
Using the previous example, say Michael gives Jasmine 200 shares of ABC Company stock he purchased for $50 each.
When Michael dies and the stock is valued at $70 per share, his death has no impact on the basis of the stock in the hands of Jasmine.
Should Jasmine later sell the gifted ABC Company stock, then she would pay capital gains taxes on the value above $50 per share.
Another consideration for making a gift of assets is gift taxes.
Generally, the giver of the gift is responsible for gift taxes.
The gifting liability begins when the gift amount exceeds the annual exclusion threshold.
In 2023, this exemption amount is $17,000.
Let us say Michael gifted the shares to Jasmine in 2018.
The exclusion in 2018 was $15,000.
His gift to Jasmine would not have triggered a gift tax.
This has been a relatively simplified discussion of what can be a rather complex subject.
If you have assets subject to the step-up in basis rule, work with an experienced estate planning attorney to create a tax-friendly estate plan.
Reference: Forbes (March 28, 2023) “What Is Step-Up In Basis?”