How Does a Step-Up in Basis Work?

By Last Updated: May 9, 2024
How Does a Step-Up in Basis Work?

The step-up in basis is a powerful tool that can help manage the tax implications of inherited assets. By understanding and utilizing this provision, heirs can significantly reduce their tax burden and simplify their financial transactions. The “basis” in the context of taxation is the value used to calculate gain or loss for tax purposes when an asset is sold. Typically, this basis is the purchase price of the asset. However, when an asset is inherited, the basis of the asset is often adjusted to its market value at the time of the original owner’s death, a process known as “stepping up” the basis.

How Does it Work?

A step-up in basis adjusts the value of an inherited asset from the original purchase price to its market value at the time of the decedent’s death. For example, if a parent purchased stock for $50,000 and it was worth $150,000 at the time of their passing, the basis would be stepped up to $150,000 for the beneficiary. When the beneficiary sells the stock, they would only be taxed on gains over $150,000, rather than gains over the original $50,000 purchase price.

Benefits of a Step-Up in Basis

  1. Reduced Tax Burden: The primary benefit of a step-up in basis is the potential reduction in capital gains tax owed by the person inheriting the asset. This adjustment can lead to substantial tax savings, particularly for highly appreciated assets.
  2. Simplified Record Keeping: Determining the original cost basis can be challenging, especially if the asset was purchased a long time ago. The step-up in basis simplifies this process by resetting the basis to the value at the time of the owner’s death.
  3. Encourages Investment in Appreciating Assets: Knowing that the basis of an asset will step up at death can encourage long-term investment in appreciating assets.

Implications for Estate Planning

The step-up in basis is a critical element in estate planning. It influences decisions about holding or selling assets and can impact the overall strategy for transferring wealth to the next generation. Some recommend retaining appreciating assets until death to take advantage of the step-up in basis, thereby minimizing the tax burden on heirs.

Potential Changes and Considerations

It’s important to note that tax laws are subject to change, and the rules regarding the step-up in basis have been points of debate in U.S. tax policy. Potential changes to this rule can significantly impact estate planning strategies, so staying informed and consulting with a tax professional is advisable.

Frequently Asked Questions:

Q: What assets qualify for a step-up in basis?

A: Most assets received as part of an inheritance qualify for a step-up in basis. This includes real estate, stocks, bonds, and mutual funds. However, certain retirement accounts like IRAs and 401(k)s do not receive a step-up in basis because they are subject to different tax rules.

Q: Does a step-up in basis apply to joint assets?

A: For jointly held assets, the step-up in basis rules can apply differently based on the ownership structure and local laws. In community property states, both halves of the property may receive a step-up in basis upon the death of one spouse. In other states, only the decedent’s portion of the property may be eligible for a step-up.

Q: Are there any exceptions or exclusions to be aware of?

A: Yes, there are exceptions. For example, assets that are gifted, rather than inherited, do not receive a step-up in basis. Instead, the recipient takes over the giver’s original cost basis. Understanding the distinction between gifts and inheritances is crucial for tax purposes.

Q: What happens if the asset has depreciated?

A: If an asset’s value has decreased at the time of the decedent’s death, the basis is stepped down to the current market value. This means if the heir sells the asset, they may realize a capital loss, which could potentially offset other capital gains.

When receiving an inherited asset, a step-up in basis is just one of a few things to consider. We recommend consulting with a financial advisor and/or tax professional to discuss your options regarding inherited assets along with overall tax planning and estate planning guidance.

Have questions? Feel free to contact us.

Casey Smith
President, Wiser Wealth Management

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