The step-up basis tax rule saved individuals about $116 billion over the last 10 years. It’s a tax provision that allows you to lock in the cost of assets. Do you know What is Stepped-up
Without the rule, you’d pay a significant amount of tax on the appreciation of inherited assets, like stocks or real estate. The step-up basis tax rule could help you reduce your tax liability if you were to inherit something of considerable value.
Keep reading for a complete guide to the stepped-up basis tax rule.
Understanding the Step-up Basis Rule
The IRS created the step-up in basis inheritance tax rules. They enable you to value assets at the fair market value at the time of inheritance.
In turn, you can use this cost basis for taxes should you decide to sell those items. In this way, the step-up basis rule enables you to reduce capital gains on inherited assets.
In some instances, however, the tax value of an asset may prove lower than when the beneficiary purchased it. In that case, the step-up basis would represent a step down in cost basis valuation.
The Idea Behind the Step up Rule
The IRS had a specific reason for creating the step-up in basis rule. A benefactor could hold assets for years or decades with considerable gains.
With this in mind, taxing the asset based on the appreciation of its original price seemed unfair. Also, in some cases, it can prove hard to determine the original price of an asset if records are no longer accessible.
As an example, imagine that your beneficiary purchased a home in 1950 for $10,000. On their passing, appraisers might value the home at $450,000. Now, the IRS would require you to pay capital gains taxes on $440,000 if it weren’t for the step-up in basis tax rules.
Understanding Capital Gains Tax
It helps to understand capital gains taxes to fully understand step up in basis tax rules. You must pay capital gains tax on any asset that’s worth more when you sell it compared to when you purchased it.
Suppose you bought a stock for $1. Two years later, however, you decide to sell the stock, and it’s worth $5.
Now, you must pay long-term capital gains for the stock. The IRS will assess your capital gains tax liability based on its appreciation of $4.
How Capital Gains Tax Comes Into Play
When it comes to capital gains tax, you must consider the length of time that you held onto an asset. This time will affect your capital gains rate.
For instance, you could hold an asset for less than a year. In that case, the IRS will tax you using the short-term capital gains rate. In other words, you’d pay taxes on the asset based on your income tax level.
Alternatively, you might hold onto an asset for more than a year. In that case, you’d pay the long-term capital gains tax rate.
You must always pay long-term capital gains tax on inherited property. The long-term capital gains rate can vary from 0% to 20%.
Understanding Adjusted Cost Basis
When considering step-up in basis, it also helps to understand adjusted cost basis (ACB). To find the adjusted cost basis, you’d start with the combined value of an asset’s purchase price.
When considering real estate, you’d add any capital improvements to the property. Now, you’d subtract any tax credits you received on the property.
The tax liability for property taxes can vary dramatically. Someone could decide to sell a home before they pass.
Alternatively, they could leave it to an heir. These scenarios would change the related tax liability.
Let’s have a closer look at the following scenarios to get a better understanding of ACB.
An Example of Tax Liability Without ACB
Imagine that your benefactor brought property for $100,000. The sale took place five years ago. Now, imagine that it’s one week before your benefactor passes, and they sold the property.
The estate must cover the capital gains tax related to the original cost basis of $100,000. In other words, as an heir to the property, you would owe taxes based on the original cost basis of $100,000.
An Example of Tax Liability With ACB
In this example, imagine that your benefactor retains ownership of the property until their passing. The adjusted cost basis rule changes things.
As the property heir, you’d become eligible for the step-up in basis tax rule. This circumstance would enable you to assess your tax liability based on the fair market value of the property at the time of your benefactor’s death.
Now, you decide to sell the property within a week of receiving it from your benefactor. From the time your benefactor passed until you sold the property, it didn’t increase in value. The IRS will not find you liable for capital gains taxes for this reason.
How Step-up in Basis Works
Usually, you’d determine the step-up basis based on the date of the death of your benefactor. In other words, you’d make this assessment based on the adjusted inherited cost basis of the asset.
You could also use an alternative valuation date. You’d make this adjustment when you file your tax return.
However, there are several conditions that you must comply with when using this method. If you use an alternative valuation date, you should do so with the help of an expert tax advisor.
Why the Step-up Basis Tax Law Matters
The step-up in basis tax rule is important for many people. Beneficiaries must report capital gains or losses when selling inherited assets.
Suppose a relative leaves you 1,000 shares of stock. Originally, your benefactor purchased the stocks for $5 per share.
Now, however, they’re worth $20 per share. Your cost basis would become $20 on each share.
Later, you might sell those stocks for $22 a share. Each stock would have a $2 per share capital gain tax liability. This is a much fairer alternative than paying the full $17 per share in appreciation based on when your benefactor originally purchased the stock.
A Note on Community Property States
If you live in a community property state, you could enjoy a double step-up basis advantage. In other words, a spouse could take the first step up basis for taking over a property. The property would go into a revocable living trust with the other spouse.
Now, imagine that the second spouse passes. The eventual beneficiary of the property would get the second step-up basis based on the date of passing of the last living spouse.
Without the double step-up basis, the heirs must sell the property using the original purchase price as the cost basis. This circumstance would create a massive capital gain.
Calculating Step-up in Basis
Again, you must calculate the step-up in basis based on the date of death of your benefactor. Also, you can use an alternative valuation date.
For now, let’s stick with using the date of death. This is a relatively straightforward calculation. In this instance, you’d take a snapshot of the fair market tax values on the date of death of the benefactor.
If the asset you inherit is stock, you’ll use the closing stock price on that date or the most recent trading day. If the asset is real estate, you’ll hire an appraiser to determine the fair market value on that date.
A Step-up in Basis Example
Let’s look at another example of the step-up in basis rule. We’ll base this example on another married couple.
The couple purchased a house for $25,000 in 1970. They live in Wisconsin, which is a community property state.
Also, the couple has 1,000 shares of company stock earned by one of the spouses. The spouse employed at that company purchased shares at different times resulting in a varying cost basis.
How Things Play Out
In the year 2000, the couple created a revocable living trust for all their assets. One spouse died in 2015.
At that time, an appraiser valued their home at $215,000, and the stocks were worth $150 per share. These amounts represent the new cost basis for the remaining spouse.
The remaining spouse decides to sell 100 shares of the stock at $110 per share. The spouse inherited the stocks at $105 per share, so they must pay $5 per share in capital gain taxes, which amounts to $500.
Now, the remaining spouse passed away in 2021. They leave their assets to their child.
The home is now worth $237,000, and the remaining stocks are worth $118 per share. The IRS will assess the child’s tax liability for this inheritance based on the tax values at the time of the remaining spouse’s death.
Using Step-up Basis as a Tax Loophole
For many people, the step-up in basis rule is an unfair tax loophole. The idea of the step-up in basis rule, however, is to help people who’ve owned assets for decades.
It enables them to pass those assets onto their children. The rule also helps to preserve the value of assets.
Yet, many people feel that the step-up in basis rule enables the ultra-rich to get away with paying millions of dollars in taxes. Meanwhile, their heirs continue to enjoy the benefits of using the assets.
A Step-up Basis Tax Loophole Example
Suppose a multimillionaire owns a stock portfolio for more than 40 years. Their beneficiaries wouldn’t pay taxes on the accumulation of those assets. Still, they could collect dividends and sell stocks without paying substantial capital gains taxes.
Now, some legislators want to eliminate the step-up in tax basis rule. Instead, they want to reduce capital gains tax rates.
These legislators believe that it’s easy enough to determine the historical cost basis for inherited assets. Moreover, they believe that eliminating the step-up in basis rule will close one of many massive tax loopholes used by the ultra-rich.
Step-up Basis and IRS Matters
The IRS uses the fair market rate to value assets at the time of a benefactor’s death. This practice enables the agency to determine the new value of an asset that a benefactor transfers to heirs.
Also, it also helps when calculating capital gains taxation on inherited property. In this way, the fair market rate makes it easier to assess taxes on gifts and estates.
More than likely, however, you’ve heard that a primary residence is exempt from capital gains tax. This is true—to a degree.
An individual can enjoy a capital gains income tax exemption of up to $250,000 on a primary residence. A married couple that files joint taxes can enjoy the same benefit of up to $500,000.
Examples of Capital Gains Taxes
Imagine a married couple brought property for $150,000. A decade later, they sold the home as their primary residence for $300,000. Their capital gains of $150,000 are tax exempt.
In another example, a couple purchases a home for $100,000. The home remains in the family for 100 years. During that time, it’s appreciated to a value of $3 million.
Over the years, the family passed the property to heirs using the step-up basis rules. As a result, the final heir could sell the property and pay minimal capital gains taxes.
Is It Too Late To Take Advantage of the Stepped-up Basis Loophole?
You may not necessarily want to sell a recently inherited property. In that case, you’ll pay capital gains taxes, and your heirs will enjoy the benefits of the property’s appreciation. Using this method, you can delay and minimize capital gains taxes for generations.
Heirs pay taxes based on asset value assessed at the date of the benefactor’s passing. They’re not subject to capital gains taxes based on the original value of a property.
Many people view the step-up basis as an unfair tax loophole for this reason. Those who share this view believe the rule enables families to pass extensive property to heirs without paying full taxes on the appreciation.
What Happens if the Law Changes?
In response to this sentiment, the current administration has created a proposal called the American Families Plan. If the plan passes in its current state, heirs must pay any taxes due on the appreciation of an asset.
Suppose someone purchases a home for $300,000. 20 years later, the home appreciates in value to $1 million, and the beneficiary passes, leaving it to heirs.
The IRS would require the heirs to pay appreciation on $700,000. Only then can they enjoy the stepped-up basis valuation of $1 million. As you can see, the American Families Plan is an important piece of legislation for people who plan to pass assets to their heirs.
What Does It All Mean?
Tax laws are highly complex and can prove confusing. Moreover, it can prove challenging to remain in compliance with tax laws, especially as legislators work toward removing the loophole for step-up in basis valuation.
It’s understandable if you have doubts about tax law compliance. If so, you should consult with a financial advisor.
It’s important to seek consultation before accepting gifts or other assets. You must also know the tax consequences of selling inherited property beforehand.
Stay Informed About Your Money
Now, you have a better understanding of stepped-up basis tax rules. Still, there’s plenty more to learn about navigating tax liabilities.
Please feel free to browse our Taxes section to learn more about the matter.