Do you imagine leaving a significant amount of wealth to your heirs? What about receiving a large inheritance? If either of these circumstances is in your future, you’ll want to understand the step-up in basis and how it could affect what you’re leaving as your legacy or what you’ll receive as the inheritor.
How the Step-Up in Basis Works
The “step-up in basis” is a tax provision that makes it possible for families to pass on certain types of assets at current market values instead of their original cost basis. Why is this important? For tax purposes, allowing heirs to avoid potentially significant capital gains taxes.
You see, generally, when appreciated assets are sold, it triggers a capital gains tax. Let’s take a piece of family property as a prime example as this is something we see left to heirs with our clients quite frequently.
If a family that has owned a piece of property for many years sells it, the gain in value since its purchase date is subject to capital gains taxes. However, under the step-up basis provision, if a parent bequeaths the property to their children, the property’s cost basis, or original purchase price, is reset to the property’s fair market value at the time of their death. If the heirs immediately sell the inherited property at the fair market value, they will owe zero capital gains taxes.
Now let’s put some numbers to it. If the owners of a bequeathed property paid $250,000 for it 25 years ago, and its current fair market value is $500,000 at the time of their death, the heirs inherit the property at its stepped-up cost basis of $500,000. That’s $250,000 that the inheritors won’t owe capital gains on!
Keep in mind, though, while they aren’t responsible for the $250,000 of capital gains in the property at the time of their parent’s death, they are responsible for taxes on gains on the property going forward. If they sell the property later for $800,000, they will be required to pay taxes on the $300,000 capital gain.
Assets transferred to family members before the owner’s death aren’t eligible for a step-up basis, putting recipients who sell the assets in the position of paying capital gains taxes based on the owner’s original cost basis.
Why Step-Up in Basis is Important
For families looking to leave a legacy and for continuity of their wealth, the step-up basis is critical because it prevents heirs from selling off other assets to pay the higher capital gains tax—plus it means the heirs can inherit more due to a lessened tax liability.
The step-up in basis is especially vital for family businesses such as farms that lack the cash on hand to cover the tax. If they are hit with a significant tax bill, many would be forced to downsize the business or sell it completely.
However, not all assets are treated the same when transferred upon the owner’s death. In planning to maximize your estate for your heirs, it is vital to understand how the IRS treats various types of assets.
Assets Eligible for a Step-Up in Basis
Most assets are eligible for a step-up in basis if they are transferred to heirs upon the owner’s death, including:
- Family residence
- Investment properties, including apartment, commercial, retail, and medical buildings
- Securities such as stocks, bonds, ETFs, and mutual funds
- Businesses and equipment
- Art, antiques, and other collectibles
- Assets held in a living trust
Asset not Eligible for a Step-Up in Basis
Generally, tax-favored investment vehicles such as qualified retirement accounts and annuities are not eligible for a step-up primarily because the owners have already benefited from significant tax breaks during their lifetimes. That means beneficiaries are responsible for capital gains on contributions made to the plan.
Non-eligible assets include:
- Qualified retirement accounts, including IRAs, 401k, 457, and 403b plans
- Defined benefit plans
- Money market accounts
- Certificates of deposit
- Assets held in irrevocable trusts
The Bottom Line
The step-up basis is a legal tax loophole that allows heirs to receive assets upon the owner’s death at current market values, thus freeing them of capital gains taxes based on the original cost basis. It’s a significant estate planning tool families we help our clients use to maximize the value of their estate for their heirs. Of course, it is essential to work with a qualified estate or financial advisor to understand how the step-up in basis affects your estate plan and to ensure your assets receive the most favorable tax treatment.
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