The benefits of stepped-up tax basis
The IRS is good at collecting tax revenue. They are also good at creating rules to (legally) avoid taxation. And while the cynical (and perhaps true) take is the rules are made for the ultra-wealthy, there are also ways for everyday people to take advantage of the system.
One of these is called the stepped-up cost basis (or tax basis), a provision of the tax code allowing unrecognized gains to be shielded from taxes when the owner of the asset dies. This provision has significant implications when someone dies holding highly appreciated assets, for example the family home that was purchased 40 years ago.
Which assets are eligible for this treatment? And how can you structure your finances to take advantage of this rule?
What is the stepped-up tax basis?
The IRS imposes taxes against income you receive. The most common type of income is income from wages from your job, but there are other forms of income. Capital gains refers to income resulting from selling an asset for more than you bought it for. The amount of the gain is the difference between the selling price and the buying price of an item. The buying price of an item is also known as the cost basis.
For example, if you buy one share of Apple stock for $100, and later sell it for $190, you would recognize capital gains income of $90.
If, however, you had died before selling the stock, your heirs would inherit the stock with a cost basis equal to the Fair Market Value (i.e. the selling price). This means your heirs would be able to sell that same asset for the same price without paying any capital gains taxes.
A real-life example
A couple years ago I worked with “Dave”, who in 2001 had purchased 100 shares of Microsoft. When I met him, he’d just learned he had a terminal illness, he had less than a year left, and he wanted help organizing his finances for his family to inherit.
One of the first things we looked at was the Microsoft stock. When he purchased the stock, it was worth around $3,500. 22 years later, it was worth nearly $34,000. If he had sold the stock, he would have recognized a gain of – and paid taxes on - over $30,000. I advised Dave it would be better not to sell.
IRC §1014 creates the concept of stepped-up cost basis. In essence, when someone dies, the cost basis of any assets they own is “stepped up” to the Fair Market Value (AKA the selling price) on the date of their death. Those unrealized gains – the amount of gain to be taxed if he had sold the stock – were erased when Dave’s wife inherited the stock. She was able to sell the stock without paying taxes on the $30,000 gain.
Which assets are eligible for stepped-up basis?
Any asset held outside of a retirement account (IRA, 401(k), etc.) or an irrevocable trust are eligible for this treatment.
The family home is typically one of the largest assets owned by average people, and since the home often has unrealized gains, it’s a great candidate for stepped-up basis. Nonqualified brokerage accounts (such as the one owned by “Dave”) are also eligible for this treatment.
How you can make it work for you
You should use the stepped-up basis concept to inform all your estate planning decisions.
First, if you can afford it, it may be wise not to sell a highly appreciated asset. If the asset is passed to your heirs at death, they can sell it without paying capital gains taxes.
Second, when you are designating your beneficiaries, consider who would most benefit from the stepped-up basis. Consider the hypothetical person who wishes to split her assets 50/50 between her only child and her favorite charity. Since the charity is tax-exempt, it would receive no benefit from the stepped-up basis. She should give the child the stepped-up basis asset and give the taxable asset to the charity.
A more common, but less dramatic, example is related to the tax rate of your respective children. If one of your kids is a doctor earning over $300,000, and the other is a government employee earning $80,000, the doctor child – due to her higher tax bracket - will see more benefit from the stepped-up basis erasing the unrealized capital gains.
About the Author
Joseph Fowler, CFP® is a financial planner and co-owner of 402 Financial in Lincoln, NE.
402 Financial provides financial planning and investment management services to people approaching or in retirement. Joe always acts as a fiduciary and never takes commissions on product sales.
Click this link to schedule a free consultation with Joe.
