A step-up in basis is an adjustment to the value of appreciated assets upon inheritance. Understand the rationale for this rule and how it impacts investments.
What Is the Step-Up in Basis?
The step-up in basis is a tax provision that helps beneficiaries lock in the cost basis of assets at the time they inherit them from a benefactor. Many assets such as stocks and real estate can appreciate massively before they pass to heirs. When someone inherits them and later sells them, they can use the date of inheritance to establish the cost basis rather than the date of purchase by the person it was inherited from.
It's important to understand that a step-up in basis only happens after a benefactor dies—taxes on assets transferred before death are subject to the original cost basis.
Step-Up vs. Step-Down in Basis
The step-up in basis follows IRS inheritance tax rules that allow the person inheriting an asset to use the fair market value of the asset at the time of inheritance as the cost basis for taxes when selling the asset. It is designed to reduce the capital gains tax for heirs on inherited assets. It is possible in some situations, however, that some assets passing to heirs may actually be lower in value at the time of death than they were at purchase, in which case the step-up basis will actually represent a ‘step-down’ in cost basis valuation instead.
Purpose of the Step-Up In Basis
The rationale behind this rule is that many assets such as property or stocks have been held for many years, if not decades, with considerable gains. Taxing the asset based on the original purchase price can seem unfair and, in some cases, cannot easily be determined if the original records no longer exist.
For example, a home purchased in 1950 may have only cost $10,000 at the time. If this home transfers ownership upon the owner’s death in 2022, and is valued at that time at $450,000, the beneficiary could be responsible for a $440,000 taxable capital gain if they were to sell the property at that time. By using the step-up in basis, the beneficiary’s adjusted cost basis becomes the $450,000 value of the home at the time of death and they do not inherit the huge unrealized capital gain liability for the prior 71 years.
Fast Fact: Cost basis is important when determining the capital gains tax on an asset that is sold. The wider the gap between the cost basis and the selling price, the more someone pays in taxes.
How Step-Up In Basis Works
Normally, the step-up in basis is determined on the date of death. This means the stock or real property’s fair market value on the date of death is the adjusted inherited cost-basis of the asset. It is also possible to use an alternative valuation date when the beneficiary files an estate tax return, though choosing an alternative valuation date has a number of conditions and should be done with the consultation of a tax advisor.
The step-up basis is important because the beneficiary will need to report any capital gain or loss when the asset is ultimately sold. For example, if the beneficiary inherits 1,000 shares of stock from an uncle purchased at $5 per share, which is valued upon the uncle’s death at $20 per share, the beneficiary’s cost basis becomes $20 on the shares. If the beneficiary later sells the shares at $22 each, they will have a $2 per share capital gain on the asset, rather than the full appreciation of $17 from the uncle’s original purchase. Conversely, if the stock is ultimately sold for less than $20, a capital loss would be reported upon sale.
Important: Establishing the cost basis is important whether you plan on liquidating immediately or down the road.
Double Step-Up Basis
Community property states may see what is called a double step-up basis. This means that a spouse is able to take the first step-up basis when taking over the property held in a revocable living trust with the other spouse. When the second spouse dies, the beneficiary would get the second step-up basis based on the date of death of the last living spouse. This is important because a spouse may need to sell a home to get closer to family and without the double step-up basis, they could be forced to sell it using the purchase price they bought it at with their spouse as the cost basis, creating a huge capital gain.
How To Calculate The Step-Up In Basis
The step-up in basis is calculated based on the date of death or by using an alternative valuation date. For those using the date of death, this calculation is relatively simple; a snapshot is taken of the fair market value on the date of death.
- For a stock: the closing stock price on that date or most recent trading date
- For a home: a fair market value is determined for that date, usually arrived at through an appraisal
Step-Up In Basis Example
Let’s look at an example to determine how the step-up in basis works. Peter and Patricia are a married couple. They purchased the family house in 1970 for $25,000 and they live in Wisconsin, a community property state. They also have 1,000 shares of stock in the company that Peter worked for until he retired. The company stock was purchased at different periods of time with a varying cost basis.
The couple created a revocable living trust in 2000, placing all of their assets in it. Peter died in 2015. At the time of his death, the house was valued at $215,000 and the stock had a value of $105 per share. This is the new cost basis for Patricia on those assets.
She decides to sell 100 shares of the stock at $110 per share so that she can fix the home’s roof. Because she inherited it at $105 per share, she only has a $5 per share ($500) capital gain.
When she passes away in 2021, her daughter inherits both assets at the new, step-up in basis of $237,000 for the home and $119 per share of stock, the current value of the assets at the time of her mother’s death.
Step-Up In Basis as a Tax Loophole
The step-up in basis is viewed as a tax loophole for many. While the intention is to help regular folks who owned assets for decades pass those assets on to children and help preserve the estate’s value, many feel that the ultra-rich get away with avoiding millions in taxes while their children still take advantage of using the assets.
For example, if a multimillionaire acquired a stock portfolio over 40 years, his beneficiaries would not pay taxes on the accumulation of assets and still be able to collect dividends or sell stocks without considerable gains.
There are legislators who propose eliminating the step-up in basis in favor of reducing the capital gains rates. Those proposing this believe that determining the historical cost basis for inherited assets is easy enough and that it will eliminate the massive tax loophole used by the ultra-rich. This would ensure that assets are taxed upon transfer to beneficiaries and that millions in taxes can be collected.
The step-up in basis is a valuable way for beneficiaries to preserve their inheritance. It allows them to use the present-day market value of assets rather than original purchase prices, often saving considerable amounts in capital gains taxes when assets are ultimately sold.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.