What is Step-Up Basis?
When you sell an asset that has appreciated in value since you purchased it, there are tax consequences. More specifically, capital gains taxes are due. Capital gains are calculated on a cost basis. If the asset is a home, the cost basis is the price paid for the home, plus any capital improvements made since you purchased the asset. The cost basis is then subtracted from the selling price to determine the capital gains. Under current tax law, if the home was not your primary residence, or you don’t meet certain other qualifications for exclusion, you would owe capital gains taxes upon the sale of the home. Similarly, if the asset was stock or securities, you would owe a capital gains tax on the net proceeds from the sale: selling price minus buying price minus expenses from the sale.
How does it work for inherited assets?
So, what are the tax consequences when you sell inherited property? That is, what are the tax consequence to a beneficiary when an inherited asset is eventually sold? What is the cost basis? What is the purchase price used? Is it the price at the time the asset was originally purchased, or the fair market value of the asset when you inherited it?
It’s more the latter. Under IRC Sec. 1014, the income tax basis of property acquired from a Decedent is based on its fair market value at the time of death of the person who bequeathed it. This is commonly referred to as a “step-up” basis. So, if you receive inherited property that was originally purchased for $200,000, but was worth $1,000,000 at the time of inheritance, the asset would receive a tax-free step-up in basis of $800,000. Going forward, if the asset appreciates in value before you sell it, you would owe capital gains taxes on that amount (assuming, of course, no other exclusions apply.) This rule follows some commonsense practicalities. Determining the value of an asset that was purchased many years ago by a person who is now deceased and may have neither records of that purchase, nor records on the improvements made to that property, may prove difficult.
However, it’s important to understand that the “step-up” in basis works both ways. If you are dealing with an asset that has depreciated between the time of its purchase and the time of the inheritance, it would receive a “step-down” basis. Accordingly, an asset purchased for $1,000,000 that now has a fair market value of $800,000 would result in a new tax basis of $800,000, and neither the deceased nor the beneficiary would be able to claim a loss against taxable income.
Estate Planning Implications
These rules have obvious implications for estate planning purposes. Holding highly appreciated assets in your estate for the benefit of your heirs, rather than selling them and distributing that income during your lifetime, can have advantageous tax results. Gifting them during your lifetime may result in both capital gains tax as well as gift tax. Conversely, holding highly depreciated assets in your estate can result in the loss of a potential tax credit.
The “Double Step-up”
An even more advantageous use of the “step-up” basis is the use of a Trust in a community property state, such as California. (Note: for more information on the difference between community and separate property, visit our prior blog article, “Is my property Community Property or Separate Property?) This allows your beneficiaries to take advantage of the “double step-up.” Here is an example of how that can work:
Alex and Jo bought a home in 1990 for $600,000. They had a revocable living trust established and deeded the house to the Trust. When Alex passed in 2016, the house was worth $1 million and remained in the Trust. Jo received the step-up in basis for the home’s market value of $400,000. When Jo passes away in 2020, the couple’s children inherit the home, now with a fair market value of $1.25 million. The children now inherit a home that has “stepped up” in basis twice and avoided paying capital gains taxes on $650,000.
Takeaway
Understanding how the “step-up” process works, and planning for it can be an essential part of your estate plan. Is your estate plan giving you the most benefit for your goals? Contact CASHMAN LAW today for a free consultation to see how we might help you understand the considerations of basis in decided how best to pass your assets.
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