By Attorney Gary Allen

When it comes to passing on wealth to your loved ones, the “step-up in basis” rule is one of the most important estate planning tools to understand. It can save your heirs a lot of money in taxes, particularly when it comes to appreciated assets like real estate and investments. Let’s break it down simply and take a closer look at how it works, what it applies to, and why it can be more beneficial than gifting assets during your lifetime.

What Is the Step-Up in Basis Rule?

The step-up in basis rule allows certain inherited assets to have their cost basis adjusted to their fair market value at the time of the owner’s death.

Cost basis is simply the original value of an asset for tax purposes. When you sell an asset, you typically pay capital gains tax on the difference between the sale price and the cost basis. But with a step-up in basis, the starting value for tax purposes gets “stepped up” to the current market value when the asset passes to your heirs.

This adjustment can dramatically reduce or even eliminate capital gains taxes when your heirs sell the asset.

Example of How It Works

Real Estate

Let’s say you purchased real estate 30 years ago for $100,000, and it’s now worth $500,000. If you were to sell the house yourself, you would owe capital gains tax on the $400,000 of appreciation (the difference between $500,000 and $100,000).

But if you pass the house to your heirs and they inherit it after your death, the cost basis “steps up” to $500,000 – its fair market value at the time of your death. If your heirs sell the property for $500,000, they would owe no capital gains tax because there’s no appreciation beyond the stepped-up basis.

Mutual Funds and Stocks

The same principle applies to investments like mutual funds and stocks. Imagine you bought shares in a mutual fund for $50,000 that are now worth $200,000. If you sell them during your lifetime, you’ll pay capital gains tax on the $150,000 gain. But if you pass these shares to your heirs, their basis becomes $200,000. If they sell the shares for that amount, they won’t owe any capital gains tax.

What The Rule Doesn’t Cover

It’s important to note that the step-up in basis rule does not apply to all types of assets. For example, retirement accounts like IRAs and 401(k)s are excluded. These accounts are taxed differently because the money in them hasn’t been taxed yet. When your heirs withdraw money from these accounts, they’ll pay ordinary income tax on the withdrawals, not capital gains tax.

Why Passing Assets at Death Is Better Than Gifting During Life

You might be tempted to give away your assets while you’re alive to help your loved ones. While this is a generous idea, it may not always be the smartest move tax-wise. Here’s why:

• No Step-Up in Basis for Gifts: 

  If you gift an asset during your lifetime, the recipient takes over your original cost basis. This means they’ll owe capital gains tax on the full amount of appreciation when they sell the asset. For example, if you give a house away while you are alive, your child will be stuck with the $100,000 basis. When they sell the house, they’ll owe tax on $400,000 of appreciation. (Note: if the house is used as a principal residence by your child for 2 of the preceding 5 years before the house is sold, there is a different IRS regulation to reduce or eliminate the capital gains.)

• Higher Taxes For Your Heirs:

  By gifting assets, you’re potentially leaving your heirs with a larger tax bill than if they had inherited the asset with a stepped-up basis.

The Bottom Line

The step-up in basis rule is a powerful tool that can significantly reduce the tax burden on your heirs. By planning carefully and understanding how this rule works, you can help preserve more of your wealth for your loved ones. If you’re unsure how this might apply to your estate, feel free to reach out. We are here to help you navigate these important decisions and create a plan that works best for you and your family.