Step-Up in Basis: Why It Matters in Estate Planning

By Lindsay Pickral, ThompsonMcMullan, P.C.

As an estate planning and estate administration attorney, I often receive questions from clients who are concerned about the tax consequences of both passing assets to their intended heirs and inheriting assets at the death of a loved one.

Recent news stories may have made you aware of the “step-up in basis” and the current administration’s desire to eliminate or adjust it. If you are considering engaging in estate planning or may be inheriting assets, you should understand what the step-up in basis is and how it may affect you.

What Is the Step-Up in Basis?

Money received from the sale of inherited assets may or may not constitute taxable income to the heir(s) of the property; the answer depends on the heir’s “basis” in the property. Through a provision in federal tax law, certain assets benefit from a “step-up in basis,” which adjusts the asset’s basis from its value at the time the owner purchased it to its value at the time of the owner’s death. 

For example, imagine a homeowner dies, leaving his house to his children through a will. When his children inherit the property, the home’s cost basis changes. (The home’s “cost basis” is the amount the homeowner originally paid for the property.) The step-up in basis adjusts the home’s cost basis from its original purchase value to its fair market value on the date of death of the homeowner. In this instance, the home’s “fair market value” is the price the property would sell for on the open market, typically determined by an appraisal or through a real estate professional.

Suppose the homeowner originally purchased the home in 1988 for $100,000, and at the time of his death in 2018, the fair market value was $300,000. The stepped-up basis in 2018 was $300,000. If the children then sell the home in 2022 for $450,000, the resulting capital gain is $150,000, which is calculated by subtracting the stepped-up basis from the sales price. The effect is that the $200,000 capital gain between the original purchase of the home and the homeowner’s death is eliminated.

Without the step-up in basis, the children who inherited the property would have had a considerably higher taxable gain after the sale, and, as a result, would likely have to pay more in capital gains tax.

It is important to note that tax consequences for capital gains are not assessed until the inherited asset is sold (for a profit).

Why Bequeath Assets Through a Will or Estate Plan?

Clients often ask whether there is a benefit to gifting assets to loved ones during their lifetime rather than at their death. From a tax perspective, the answer is usually no.

Assets transferred or gifted prior to the purchaser’s death do not receive a stepped-up basis and instead, the purchaser’s cost basis is used to determine capital gain. Capital gains tax is then calculated based on the difference between the original owner’s cost basis and the gift recipient’s eventual sales price (after considering any depreciation or other capital gains exclusions that may apply).

As a result, it’s often far more beneficial to pass assets to your loved ones at your death through your will or estate plan. This ensures the beneficiaries receive the step-up in basis and, typically, a much lower capital gains tax.

What Assets Receive a Step-Up in Basis upon a Person’s Death?

The step-up in basis can apply to many kinds of assets, including (but not limited to):

• real estate
• personal property
• brokerage accounts
• stocks
• bonds
• bank accounts
• businesses
• art
• antiques
• collectibles

Step-up in Basis at Death of Spouse

Under federal law, all community and marital property is given a new basis when one spouse dies. The death of that spouse bumps jointly held property up to the fair market value at that time. Then, subject to certain exceptions, the property of the surviving spouse receives a second step-up in basis at the second spouse’s death.

When Does the Stepped-Up Basis Not Apply?

Some assets qualify for a stepped-up basis, whereas others do not. The stepped-up basis does not apply to the following types of assets:

• IRAs
• employer-sponsored retirement plans
• 401(k)s
• pensions
• tax-deferred annuities
• gifts made before death

Why Do Some Believe the Step-Up in Basis Should Be Eliminated?

Many Americans believe the stepped-up basis creates an inequitable tax loophole that allows people with significant assets to shelter these assets from capital gains tax if they dispose of them through their estate.

For example, in the scenario above, if the home was initially purchased for $100,000 and sold by the homeowner’s heirs for $1,000,000 shortly after the purchaser’s death, $900,000 of capital gains would go untaxed.

Meanwhile, a homeowner who sells his property during his lifetime will likely not get equal tax benefits (even considering the $250,000 personal residence capital gains exclusion) and may face a hefty capital gains tax bill.

On the other side of this argument are those who posit that eliminating the stepped-up basis could lead to double taxation. From their viewpoint, heirs of an estate could face capital gains tax consequences as well as estate tax consequences. However, given the current federal estate and gift tax exclusion, which is $12.92 million in 2023, only the very wealthy would likely be affected. That said, the federal exclusion is set to be cut by approximately half after 2025. In that case, the potential for double taxation would impact a much larger group of Americans. 

Navigate Estate Planning with a Qualified Attorney

Setting up a customized estate plan to avoid capital gains taxes is often a complex endeavor, and working with qualified professionals to determine what is best for you is critical. Every person’s situation is different, and there is no one-size-fits-all solution.

Although saving money on capital gains may seem attractive, there are situations where other considerations are more important, or even possibly more tax-effective. 

If you are considering whether you or a loved one may benefit from a step-up in basis or have questions regarding capital gains taxes, the Elder Law and Estate Planning attorneys at ThompsonMcMullan are available to discuss your options.