Step-Up in Basis

What Is a Step-Up in Basis?

Step-up in basis refers to the adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent's death. Cost basis, more commonly the price paid for an asset, is what determines the taxes owed, if any, when the asset is sold.

Step-up in basis, or stepped up basis, is what happens when the price of an inherited asset on the date of the decedent's death is above its original purchase price. The tax code allows for the raising of the cost basis to the higher price, minimizing the capital gains taxes owed if the asset is sold later.

The step-up in basis provision applies to financial assets like stocks, bonds and mutual funds as well as real estate and other tangible property.

Of course, if the price of an asset has declined from that paid by the owner's date of death, the asset's cost basis would step down instead of stepping up for heirs.

In practice, most cost basis adjustments after death are steps up, not steps down. This is because financial assets passed on to heirs are often long-term holdings, while financial assets and real estate tend to have positive long-term rates of return.

Key Takeaways

  • A step-up in basis resets the cost basis of an appreciated inherited asset for tax purposes.
  • The cost basis for heirs is raised to the asset's market value on the prior owner's date of death, reducing future capital gains taxes.
  • Residents of states with community property laws or those with assets in community property trusts qualify for a step-up in basis on community property for the surviving spouse.
  • Because the benefits of the step-up basis mostly accrue to the wealthiest households, opponents have tried to limit or eliminate the provision in recent years, without success.
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Step-Up In Basis

Understanding Step-Up in Basis

A step-up in basis resets the cost basis of an inherited asset from its purchase (or prior inheritance) price to the asset's higher market value on the date of the owner's death.

For example, let's suppose Jane purchases a share of stock at $2 and dies when its market price is $15. Had Jane sold the stock before dying at $15, she (or her estate after her death) would be liable for capital gains tax on a gain of $13.

Instead, her heir's cost basis becomes $15 so that if the stock is later sold at that price no capital gains tax would be due. Capital gains tax that would have been due on the rise in the share price from $2 to $15 absent Jane's death is never collected.

Tax basis is the cost of an asset to its owner, as calculated and adjusted for tax purposes. It is used to assess capital gains as well as depreciation, amortization, and depletion.

Step-Up in Basis for Community Property States and Trusts

Residents of nine community property states including California can take advantage of the double step-up in basis rule. The rule provides a step-up in basis on community property—all assets accumulated during marriage other than inheritances and gifts—for the surviving spouse.

In other states, assets owned solely by the surviving spouse do not receive the step-up in basis, and jointly owned assets receive only half the step-up in basis they would receive in a community property state.

Alaska, Kentucky, South Dakota and Tennessee allow residents as well as non-residents to create community property trusts qualifying held assets for community property tax treatment, including the double step-up in basis rule, under federal tax code.

Consider Ann and Bill, a hypothetical married couple living in a common-law, rather than a community property, state. They hold stock worth $200,000 in a joint brokerage account with a $100,000 cost basis at the time of Bill's death. Under common law principles legislated in most states, Ann would be entitled to a step-up in basis on Bill's half of the brokerage account, or $100,000 in current value, but not on her half. So the tax basis for stock held in the account would rise to $150,000 instead of $200,000 as in community property states or under community property trusts.

Note that the surviving spouse anywhere in the U.S. would be entitled like any other heir to the stepped up basis on inherited assets previously owned solely by the deceased.

Step-Up in Basis as a Tax Loophole

The step-up in basis tax provision has often been criticized as a tax loophole for the wealthiest families. The Congressional Budget Office (CBO) has estimated nearly half the aggregate benefit accrues to the top 5% of taxpayers by income. In 2020, the CBO estimated the provision's cost in foregone tax revenues at $110 billion over a 10-year period.

Some defenders of the stepped up basis have argued that eliminating it might provide a disincentive to save and subject estates to double taxation in combination with the federal estate tax. Following the doubling of the federal estate tax exemption in 2017, a modern-era record low 0.04% of adult deaths in 2020 produced an estate tax liability.

In 2021, a proposal backed by President Joe Biden and some Democrats that would have eliminated the step-up in basis for assets in excess of $2.5 million (plus $250,000 for a home) for a married couple failed to secure congressional approval.

How Is Step-Up in Basis Calculated?

A step-up in basis resets the cost basis of an inherited asset to its market value on the decedent's date of death. If the asset is later sold, the higher new cost basis would be subtracted from the sale price to calculate the capital gains tax liability, if any.

How Is Step-Up in Basis Treated Differently in Community Property States?

In community property states (and for assets in community property trusts) the surviving spouse receives a step-up in basis for community property. In the majority of states without community property provisions, jointly-owned property such as stock in a joint brokerage account would receive only half the step-up in cost basis compared with the same account in a community property state after the death of a spouse.

Is Step-Up in Basis a Tax Loophole?

The step-up in basis is a duly legislated provision of the U.S. tax code, though it is certainly responsible for a significant loss of public revenue. Because the exemption from capital gains taxes on assets held until death disproportionately benefits the wealthiest households, disparaging descriptions are likely to persist.

Article Sources

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