If you have been fortunate enough to invest steadily for the long term in stocks, real estate, or other appreciating assets, you may find yourself holding a sizable fortune late in life. The smart move is to leave these assets to heirs, to take advantage of the step-up in basis rules and avoid taxes.

A step-up in basis resets the value of inherited assets to current market value—not the original purchase price of the asset—for tax purposes. For heirs, this essentially wipes accumulated value off the slate, so they do not pay capital gains taxes on years of appreciation.

For example, say you bought a condo in 2000 for $250,000. When your daughter inherits it, it is worth $600,000. Her step-up basis is $600,000 and she faces no tax bill for the $350,000 increase in value. If and when she sells the condo, she will pay capital gains only on the amount of the sales price that exceeds her $600,000 cost basis.

By contrast, if you, the original owner, sold appreciated stocks or property, the cost basis would be set to the value of the asset when purchased. You would owe federal capital gains taxes as well as any applicable state and local taxes on the full difference between the cost basis and the sale proceeds. For a strong-performing stock portfolio, the gain could be in the millions and the tax bite could be painfully large. 

The step-up in basis benefits families who are not wealthy enough to trigger the estate tax but still have considerable accumulated assets to pass on. The exemptions to the estate tax are now so large that few estates qualify, so the capital gains tax is a bigger concern. This rule provides some relief, allowing heirs to keep every cent of a healthy stock portfolio, or sell it and pocket the full market value.

To make sure a surviving spouse can take advantage of the step-up basis, consider using a revocable trust. For real estate or stocks held jointly with right of survivorship, the inheriting spouse can take the step-up basis only on half of the assets. However, if the property or assets are held for beneficiaries in a revocable trust within the estate, the spouse or any other beneficiary will receive the step-up basis.

Note that to take advantage of the step-up in basis, the assets must be in a trust and within the estate. Trust assets outside of an estate that are passed on before death are considered a living gift and do not qualify for the step-up in basis.

Those living in community property states can take advantage of a double step-up rule. A house placed in a revocable living trust can go to a surviving spouse, who will receive the step-up in basis. When that spouse dies and a son inherits the home, he will also receive a second step-up to the current market value.

One additional feature helps your heirs capitalize on the step-up even more. Normally the basis for stocks is set to their value on the date of the owner’s death. However, the executor of the estate can also opt to use an alternative valuation date six months later. This is helpful if the death occurs in a time of extreme market volatility.

Allocating your assets with this tax rule can help minimize the tax burden on otherwise-taxable assets. Contact us to discuss how this might fit into your tax planning and estate plans. 

–Toni Shears

Sources:

Jeffrey Kennon. How the Stepped Up Basis Loophole Works, from The Balance, January 22, 2020. https://www.thebalance.com/how-the-stepped-up-basis-loophole-works-357485

Will Kenton; “Step Up in Basis.” Investopedia, April 19, 2020.  Step-Up in Basis.
https://www.investopedia.com/terms/s/stepupinbasis.asp

Marquette Bank & Trust Investment Services. Taking Full Advantage of the Maximum Step Up in Tax Basis. https://emarquettebank.com/financial-management/trust-investment-management/todays-estate-analyst/taking-full-advantage-of-the-maximum-step-up-in-ta/