Throughout my career as a CPA and financial advisor, I’ve had clients progress through a number of financial milestones throughout their lives. One topic that’s always important, but can be challenging to discuss, is the idea of transferring assets from an aging person to their next of kin. This is where the step-up in basis provision comes into play. Not many people know or understand what a step-up in basis is, but it’s important to anyone who is creating an estate plan and has capital assets.
In this article, I explain what a step-up in basis is and what you need to know when you’re deciding how to move assets to future generations so they don’t lose value.
To understand what a step-up in basis is, you must first understand what cost basis is means when we’re discussing capital assets. So, what is cost basis?
Short answer: Cost basis is the original purchase price of an asset that is used to calculate the taxes owed on that asset.
Throughout an individual’s life, purchases are made and significant investments, particularly capital investments, can carry increasing value the longer they’re in your possession. Capital assets are significant pieces of property that include homes, cars, investments properties, stocks, bonds, and even high value collectibles such as art. What you paid for them at the time of purchase is referred to as cost basis. Cost basis matters because it’s the starting point for any gain or loss of calculation.
For example, if grandma and grandpa purchased a vacation home on the Jersey Shore in 1980 for $500,000, cost basis for that house would be recorded at $500,000.
After time of purchase, cost basis either appreciates, or depreciates, in value depending on a number of variables. Either way, however, it’s important to establish cost basis no matter when you plan on liquidating.
What is a step-up in basis when discussing transferring capital assets?
Short answer: A step-up in basis refers to when the value of an asset (such as a house) is adjusted from its initial cost to its current market value upon the owner’s death.
Using the same example of grandma and grandpa’s Jersey Shore vacation home, let’s look at how much it is now worth in 2023, which is $2 million. If grandma and grandpa sell the house before they die, they would be liable for significant capital gains taxes on the increased value, paying taxes on the gained value of $1.5 million.
However, if grandma and grandpa keep the house until they die, then pass it on to family members in their wills, the step-up basis provision would then change cost basis of this home to its 2023 market value; that is, $2 million. This has a huge impact now on the capital gains taxes paid; if grandma and grandpa’s heirs decide to sell the home, they will only pay taxes on the capital gains above $2 million, instead of capital gains above $500,000.00.
When the time comes for capital assets to transfer ownership, there are always tax implications that need to be considered based on the value of the property. When the owner of a particular asset passes away, a step-up in basis resets the original cost basis of an appreciated (or depreciated) inherited asset with a capital gains tax basis of the fair market value at the day of death. The step-up in basis provision also applies to financial assets like stocks, bonds, and mutual funds as well as real estate and other tangible property.
However, if an asset is inherited by the heir when it is passed on after death, cost basis is adjusted to the higher price, minimizing the capital gains taxes owed if the asset is sold later.
Why should we care about a step-up in basis?
Short answer: A step-up in basis is an important concept in regards to taxation and estate planning, especially when considering inheritance and transferring of valuable assets to the next generation.
There are three reasons why you should be aware of a step-up in basis:
1. Capital gains tax savings & reduced tax burden
A step-up in basis protects you from inheriting costly tax implications that an inheritor may not anticipate. When you inherit an asset and a step-up in basis is applied, your capital gains tax liability is calculated based on the asset’s value at the time of inheritance, not the original owner’s purchase price. This can lead to substantial tax savings. If there wasn’t a step-up in basis, you’d be expected to pay the capital gains tax on the entire gain from the original date of purchase.
2. Preserves & protects wealth for an efficient transfer of assets
It helps protect wealth while maintaining the value and appreciation of assets as the property passes through generations. This can be particularly important for family-owner businesses and valuable real estate.
3. Encourages long-term investments
If your investment significantly increases in value as time goes on, the step-up in basis is an incentive for the owner to hold on to those assets since they won’t have to worry about being subject to capital gains tax later.
Is a step-up in basis different in regards to stocks, bonds, or other financial instruments?
Short answer: Since stocks, bonds, and other financial instruments are tangible inherited assets, they are handled in the same way.
Stocks, bonds, and financial instruments are capital assets whose value will increase and decrease over time. As they appreciate and depreciate, so does their value, just like real estate. That value is subject to increased taxes when the owner, or heir, decides to sell the property.
Our stocks have been underperforming. Is there such a thing as a step-down in basis?
Short answer: Yes, when property’s value reduces over time, a step-down basis can occur.
Any tangible capital asset is susceptible to a decrease in value. A house can depreciate when it isn’t maintained, a car can have too many miles, a rusted exterior, and a business you hold stock in can downsize. When a property is sold during a time of depreciation, cost basis and the capital gains tax will be adjusted accordingly.
Are there any assets that don’t get a step-up in basis?
Short answer: Yes there are a few assets that may not be eligible for a step-up in basis.
Pensions, tax deferred annuities, certificates of deposit, and money market accounts may not be eligible for a step-up in basis.
What if we decide to “gift” our capital assets? Is that more beneficial?
Short answer: A gift basis can be a good way to protect against harsh tax implications too, but has restrictions.
Another option that can be considered, is a gift basis for capital assets that are gifted to an heir. In this case, the property’s value is adjusted to the fair market value at the time it is gifted and the gift tax is paid on that property. The basis stays the same as it would be in the hands of the preceding owner unless the value had depreciated at the time it is gifted. Determining the loss basis will then be based on the fair market value.
It’s important to note however, that this is beneficial if you don’t plan on selling it, you can hold onto it just as you would hold on to stocks and bonds in a portfolio. While you have the property, you can enjoy it, reap the benefits and ride out the volatile times. Then, when you pass, you can will it to your heirs with the same outcome.
The step-up in basis is a valuable way for beneficiaries to preserve their inheritance and maintain the present-day market value in their favor, often saving considerable amounts in capital gains taxes when assets are ultimately sold.
At Winthrop Partners, we recognize the importance of maximizing the value of you and your loved ones assets and that setting up a customized estate plan is an important aspect of your retirement planning journey. When designing and implementing a portfolio, there are plenty of variables that have to be considered. As a fee-only fiduciary, we take pride in helping you work through your options and assist in managing your choices. Whether you need help with retirement planning, investment management, or tax planning, we’re here to help you create a long term plan that works in your best interest.
To learn more about how Winthrop Partners can help you manage your retirement plan and diversify your portfolio, contact us today for your free consultation.
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Thomas Bunting is a Financial Advisor at Winthrop Partners. He has more than 50 years of experience in accounting, financial planning, and tax planning. Prior to joining Winthrop Partners, Tom held the roles of partner, managing partner, and senior partner with a mid-sized CPA firm that provided a full range of accounting, tax and financial planning services.
Tom is a member of the American Institute of Certified Public Accountants, the Personal Financial Planning and tax sections of the American Institute of Certified Accountants, and the Pennsylvania Institute of Certified Public Accountants. He was also a former member of the AICPA governing council and a past president of the PICPA. He earned his BS in Accounting from Temple University.