When managing the complexities of estate planning or becoming a beneficiary, understanding the concept of the “step-up in basis” is essential. For many, it’s a hidden gem in the U.S. tax system that can result in significant tax savings when inheriting property or other assets. However, it is often surrounded by confusion and misunderstandings.
This guide will walk you through what the step-up in basis is, how it applies to inherited assets, and why it’s a key tax strategy in estate planning. Whether you're an estate planner guiding your clients or a beneficiary managing an inheritance, this knowledge could be a game-changer.
At its core, the step-up in basis is a provision in tax law that adjusts the cost basis of an asset to its fair market value (FMV) on the date of the owner’s death. The term “basis” refers to the original value of an asset, used for determining gains or losses when the asset is sold.
For example:
However, if you inherit the property after your grandfather’s passing, the step-up in basis adjusts the property’s cost basis to its FMV of $500,000 at the time of his death. If you sell the property for $500,000, you owe no capital gains tax since the step-up in basis eliminated any taxable gain.
The step-up in basis offers significant benefits to beneficiaries and estate planners, such as:
Without the step-up in basis, beneficiaries would owe taxes on the difference between the original purchase price of the asset and its selling price. By resetting the cost basis to FMV, it drastically reduces or even eliminates taxable gains.
The step-up in basis simplifies the transition of assets. Beneficiaries don’t have to go through extensive accounting to determine capital improvements or depreciation adjustments made over decades.
Avoiding large capital gains taxes ensures that families keep more of their inherited wealth. This wealth can then be reinvested or used for personal goals rather than being lost to taxation.
Not all assets are eligible for a step-up in basis. Here’s an overview of common asset types that do and do not qualify:
When planning estates or managing inheritances, it’s critical to identify which assets may receive a step-up in basis to fully leverage potential tax benefits.
To illustrate, here’s a more detailed example:
Scenario 1:
Outcome:
Thanks to the step-up in basis, Sarah’s new cost basis in the home is $750,000. If she chooses to sell the home for $750,000, she owes no capital gains tax. Without the step-up, her taxable gain would have been $600,000 ($750,000 - $150,000).
This mechanism can make inheriting appreciated assets far less financially burdensome and ensures a smoother ownership transition.
While the step-up in basis is a valuable tax tool, it’s not without exceptions. Here are a few critical considerations:
For married couples who own community property in states like California or Texas, a double step-up in basis may apply. When one spouse passes away, the entire property (not just the deceased spouse's share) gets a step-up in basis.
To take advantage of larger estate tax exemptions, married couples can employ top-level tax planning strategies such as portability. A qualified estate planner can ensure these exemptions work harmoniously with the step-up in basis rules.
The step-up in basis primarily applies to assets located within the U.S. If the inherited property is overseas, tax rules from that specific jurisdiction may override the U.S. rules.
Tax laws can change. Proposals to alter or eliminate the step-up in basis surface periodically. Estate planners and beneficiaries should remain vigilant and consult professionals to understand how legislative changes might affect their plans.
The step-up in basis is one of many potential strategies in estate planning. Others include gifting assets while alive, establishing trusts, or setting up family partnerships. However, these strategies may have their unique tax implications and benefits.
For example:
Every approach has its pros and cons, and one-size-fits-all solutions rarely exist in estate planning. Customized advice from an expert is highly valuable.
If you're looking to benefit from the step-up in basis, here are some practical steps to consider:
Keep detailed records of your investments, real estate, and other assets. Tracking FMV annually eases the process of calculating a step-up in basis when the time comes.
Estate planning attorneys and financial advisors can create tailored strategies that maximize the tax benefits of the step-up in basis.
Efficient estate planning ensures that assets are properly transferred while minimizing tax liabilities for your loved ones.
Tax laws fluctuate, so stay informed about relevant changes and work with professionals to periodically reassess your estate plan.
The step-up in basis is a critical yet under-appreciated component of estate planning. For beneficiaries, it can radically reduce your tax burden. It’s a powerful tool to preserve wealth for future generations.
At SD Mayer & Associates, we’re here to make sense of complex financial strategies and simplify the decisions that shape your future. If you’re unsure how the step-up in basis applies to your situation, or if you’re ready to take the next step in securing your legacy, schedule a consultation with one of our expert advisors today.