What Is a Step-Up in Basis?

The term step-up in basis refers to the readjustment of the value of an appreciated asset for tax purposes upon inheritance. Put simply, a step-up in basis adjusts the value of an asset when it passes from an owner to their heir. The higher market value of the asset at the time of inheritance is considered for tax purposes. When an asset is passed on to a beneficiary, its value is typically more than what it was when the original owner acquired it. The asset receives a step-up in basis so that the beneficiary's capital gains tax is minimized. A step-up in basis is applied to the cost basis of property transferred at death.

Key Takeaways

  • A step-up in basis readjusts the value of an appreciated asset over a period of time for tax purposes.
  • It is applied to the cost basis of property transferred at death.
  • Step-up in basis is used to calculate tax liabilities for inheritance assets.
  • Transferred assets receive a step-up in basis so the beneficiary's capital gains tax is minimized.
  • Economists have proposed eliminating the step-up in basis system and replacing it with lower capital gains taxes.
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Step-Up In Basis

Understanding Step-Up in Basis

A step-up in basis reflects the changed value of an inherited asset. For example, let's suppose an investor purchases shares at $2 and leaves them to their heir when they are $15. This means the shares receive a step-up in basis. This makes the cost basis for the shares the current market price of $15. Any capital gains tax paid in the future will be based on the $15 cost basis, not on the original purchase price of $2.

The step-up in basis rule changes tax liability for inherited assets in comparison to other assets. Let's say Sarah bought a loft in the year 2000 for $300,000. When Paul inherits the loft after Sarah's death, the loft is worth $500,000. When Paul sells the loft, his tax basis is $500,000. He pays taxes on the difference between the selling price and his stepped-up basis of $500,000. In the event there wasn't a step-up in basis, Paul would pay taxes on the difference between the selling price and the initial buying price of $300,000.

Tax basis is the dollar amount of a taxpayer's investment in a given piece of property. It is typically calculated for tax purposes, such as calculating figure depreciation, amortization, and other property dispositions.

Step-Up in Basis for Community Property States

Residents of community property states, such as Wisconsin, may take advantage of the double step-up in basis rule. For example, Allan and Jo Ann bought a home in 1977 for $350,000. They had a revocable living trust established and deeded the house to the trust.

When Allan died in 2006, the house stays in the trust, and Jo Ann receives the step-up in basis for the home's market value of $500,000. When Jo Ann passes away in 2015, the couple's daughter Stephanie inherits the home. The home's market value of $700,000 becomes her cost basis. This means that Stephanie inherits a home that steps up in basis twice and avoids paying a large amount of taxes because of the double step-up rule.

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 ultra-rich and wealthy. They take advantage of it to eliminate or reduce their tax burden. For example, they can escape capital gains tax on stocks by placing their holdings in a trust fund for their heirs.

A typical scenario might be a millionaire who invests in assets, such as real estate and stocks, that are expected to appreciate. As a result, these assets would provide them with a consistent rate of return during their lifetime. The investor's heirs will enjoy the benefits of the investment after their death because they will be taxed on the stepped-up cost basis, instead of the original cost. This allows them to avoid millions of dollars in taxes.

Over the years, economists have proposed eliminating step-up in basis and have suggested that it could be replaced with lower capital gains taxes. Proponents of the provision argue that it is not difficult to calculate the exact value of assets that may be from several decades or, in some cases, even a century ago.

President Joe Biden's tax plan includes provisions to revoke step up in basis loophole. If passed, this would force wealthy individuals to pay taxes at ordinary rates on capital gains.

Example of a Step-Up in Basis

A person who inherits mutual funds receives a step-up in basis for the funds' value. The price of the shares on the day the owner dies becomes the heir's cost basis. The heir provides the mutual fund company proof of identity along with a death certificate, probate court order, or other documentation. The company either transfers the shares to an account in the heir's name or sells the shares and sends the proceeds to the heir.

How Is Step-Up in Basis Calculated?

A step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance. For example, supposed an investor bought a loft in 2000 for $300,000 and, when it was inherited by the beneficiary, it was worth $500,000. So, the beneficiary's tax basis would be $500,000. The beneficiary sells the loft for $750,000, which means that they will have to pay taxes on the difference between the selling price of $750,000 and their stepped-up basis of $500,000. In other words, they will pay taxes on the amount of $250,000.

Does Step-Up in Basis Benefit the Beneficiary?

A step-up in basis is applied to the cost basis of the asset transferred at death; the higher market value of the asset at the time of inheritance is considered for tax purposes. When an asset is passed on to a beneficiary, its value is usually more than what it was when the original owner acquired it. So, a step-up in basis typically minimizes the beneficiary's capital gains tax if and when they dispose of the asset. In the above example, if there wasn't a step-up in basis, then the beneficiary would have to pay taxes on the difference between the selling price of $750,000 and the initial buying price of $300,000 (or on the amount of $450,000).

Is Step-Up in Basis a Tax Loophole?

The step-up in basis tax provision has often been criticized as a tax loophole for the ultra-rich and wealthy because it's possible for them to take advantage of it to eliminate or reduce their tax burden. For example, they can escape capital gains tax on stocks by placing their holdings in a trust fund for their heirs. Over the years, economists have proposed eliminating step-up in basis, suggesting that it could be replaced with lower capital gains taxes. As of yet, none of these proposed changes have been implemented.