“Step-up in basis” may sound like confusing legal jargon, but it’s actually a simple concept that can lead to significant tax savings for heirs when they sell inherited assets. Here, we’ll break down what step-up in basis means, how it works, and why it’s an essential part of estate planning.
What Is Basis?
Basis, or cost basis, is basically the original value of an asset for tax purposes. It’s used to calculate any gain or loss when you sell that asset.
Example: Let’s say you buy a home for $500,000 and later spend $100,000 on improvements. Your cost basis would now be $600,000. If you sell the home for $1,600,000, you’d have a $1,000,000 gain (minus any exclusions), and this gain would be subject to capital gains tax.
Giving the Asset as a Gift During Your Lifetime
If you gift this home to your child while you’re alive, they “inherit” your original cost basis. So, in this case, the child’s basis would also be $600,000. If they later sell the home for $1,600,000, they’d face capital gains tax on the $1,000,000 gain – just as you would have if you’d sold it yourself.
The Step-Up in Basis Advantage
Here’s where step-up in basis comes in as a big advantage. If you pass the home to your child at your death such as through a will, revocable living trust, or transfer on death deed, instead of as a gift during your life, something very helpful happens: the cost basis of the home “steps up” to its fair market value (FMV) at the time of your death.
Example with Step-Up in Basis: If the home’s FMV at the time of your death is $1,600,000, the child’s basis becomes $1,600,000. If they sell the home for that amount, there’s no capital gain because the sale price matches the stepped-up basis – meaning they wouldn’t owe any capital gains tax.
Why Step-Up in Basis Is So Valuable
The step-up in basis offers a major tax-saving benefit. Here’s why:
Eliminates Capital Gains Tax for Heirs: By getting a stepped-up basis, heirs avoid paying capital gains tax on the property’s appreciation over the original owner’s lifetime. In the example above, the $1,000,000 gain that would have been taxable if given as a lifetime gift is avoided entirely.
A Tax-Efficient Transfer of Wealth: For assets that have appreciated a lot, step-up in basis allows for a more tax-efficient way to transfer wealth, especially with assets like real estate or stocks.
In Summary: Estate Tax or Capital Gains Tax – But Not Both
Think of step-up in basis as a rule that generally makes inherited assets subject to either estate tax or capital gains tax, but not both. For estates that are too small to be subject to estate tax (less than $13,610,00 per person at the federal level and less than $2,193,000 in Washington state) this means no tax. For families holding highly appreciated assets, knowing how and when to pass them on can make a huge difference. By passing on assets at death instead of as gifts during life, loved ones benefit from the step-up in basis and can keep more of the inherited value without facing capital gains taxes.
Want to learn more about how to maximize the estate you leave to your loved ones? Reach out to our trust and estate attorney today!
The information provided in this blog post is for general informational purposes only and should not be construed as legal, financial, or tax advice. Laws and regulations vary by jurisdiction and may change over time, affecting the accuracy and applicability of the information provided. Always consult with a qualified attorney, accountant, or financial advisor to discuss your specific situation before making any decisions. This post does not create an attorney-client relationship between the reader and the author or their firm.
Comments