If you intend on leaving your assets to heirs, it is important to understand how the process works. It’s also important to understand the process if you are the heir. Whether the inheritance is real estate, investments, or other capital assets, you’ll need to become familiar with the term “step-up in basis.” In a nutshell, it means the IRS “resets” the market value of the inherited asset, and the cost basis is “stepped up” to the investment’s value on the date the original owner passes.
This is great news for heirs since it generally means the amount you pay in capital gains taxes is lower than if this law wasn’t in effect, which can save you a lot of money. Tax breaks like these need to be taken advantage of whenever the opportunity arises.
It should be noted that the step-up basis loophole applies to only non-qualified investments—those investments that don’t normally get preferential tax treatment. Qualified investments [e.g., 401(k)s or IRAs] are 100% taxable as ordinary income regardless of their cost basis. The exceptions are Roth IRAs, which are tax-free vehicles.
Capital Gains Taxes
According to the tax code, capital gains are a special category of tax imposed when an asset is sold. Capital gains are based on the amount that the asset has gained in value. This is different from income tax, which is imposed on salary and wages.
Capital gains apply to the profits from selling an asset, so the original purchase price matters. The IRS calculates the profit by subtracting the sale proceeds from that asset’s original cost basis.
There are also long-term and short-term capital gains, the difference being how long you’ve held onto the assets before selling them. As a rule, long-term investments are those you keep longer than one year, while short-term investments are kept less than one year.
The tax rate depends on the current tax code. Currently, you’ll pay 0%, 15%, or 20% in capital gains taxes depending on your income and filing status.
To qualify for 0% capital gains, your taxable income needs to be below:
Single: $40,400/year
Married filing jointly: $80,800/year
Stepped-Up Basis Mechanics
As mentioned, the step-up in basis allows heirs to pay less in capital gains taxes on the inherited asset when sold. Let’s look at an example below:
Steven’s uncle purchased $10,000 of Microsoft stock in 1992. Upon his death, the shares were worth $125,000. Tammy, Steve’s sole beneficiary, receives a step-up in basis to $125,000, which means she’s only responsible for capital gains tax on any amount above $125,000 when sold.
Another benefit for Tammy is that any capital gain (or loss) that results from the sale is coded as long term regardless of how long she or Steven held the asset. This fact is beneficial for most people since taxes on long-term gains are less than short-term gains, which are taxed as ordinary income.
The step-up in basis is a good way to receive assets from family members virtually tax-free. It adjusts the capital gains tax owed to be as low as possible. But it applies only to investment assets that are passed on due to the owner’s death, such as real estate, stocks, bonds, or mutual funds.
When it comes to estate planning, the step-up in basis is important because it minimizes the amount paid to the IRS—and no one wants to pay more tax than necessary.
The step-up in basis should not be confused with the “carryover basis,” which applies to gifts made during the giver’s lifetime:
Bob owns 200 shares of Amazon stock with a purchase price of $300/share, putting his cost basis at $60,000. He wants to help his 25-year-old grandchild Timmy and gifts him the shares. Timmy will not owe any taxes upon receiving the shares but will pay capital gains taxes when they are sold above and beyond the original cost basis of $60,000 (200 shares x $300).
This strategy can potentially save Bob money in estate taxes upon his passing, depending upon the size of his estate.
Conclusion
Because of the tax laws regarding the step-up in basis, heirs can pay fewer taxes on the assets their family members leave to them. The rules can be complex because factors such as purchase price, the current value of the asset, and the value of the asset when it’s sold make a difference in the amount of taxes paid.
With so many variables at play, it’s recommended that you consult with a financial advisor to help guide you as you create an estate plan. If you are the one inheriting an asset, consider consulting a financial planner as soon as possible. This way, you will be prepared come tax time and can thoughtfully decide how long you wish to keep the asset before selling it or leaving it to another heir.
Discuss your situation with a fee-only financial advisor.
Don’t take anything we say as tax or legal advice. We are not licensed as CPAs, tax preparers, or attorneys.
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