Step-up in basis is a term frequently referenced in tax discussions, particularly in the context of inherited assets. Below, we will explore its definition, implications, and other related nuances to provide a comprehensive understanding of this important financial concept.
What Is Step-Up in Basis?
Step-up in basis refers to the adjustment in the cost basis of an inherited asset to its fair market value (FMV) on the date of the decedent's death. The cost basis is essentially the original value of an asset used to determine capital gains taxes when the asset is sold. It includes the purchase price plus any costs incurred to improve or maintain the asset over time.
When an asset is inherited, if its FMV at the time of the decedent's death is greater than its original purchase price, the tax code allows for the cost basis to be "stepped up" to this higher value. This means potential capital gains taxes owed when the asset is sold can be minimized or even eliminated.
How It Works in Practice
To illustrate, consider an example: Jane buys shares of stock for $2 each. Upon her passing, these shares are worth $15 each. Had Jane sold the shares before her death, she would have incurred a capital gains tax on the $13 gain per share. However, as her heir, the cost basis for the shares transfers at $15, meaning if the heir sells them at that price, no capital gains tax will be owed.
When Does Step-Down in Basis Occur?
It is crucial to note that if the value of the asset has decreased by the time of the owner’s death, the basis does not step up; instead, it steps down. This situation is less common for assets that have historically appreciated over long periods but can still happen, especially in volatile markets.
Key Takeaways About Step-Up in Basis
- Resets Cost Basis: A step-up in basis resets the cost basis of an inherited asset to its FMV at the time of death.
- Reduction in Capital Gains Tax: Adjusting the basis upwards can significantly reduce future capital gains tax for heirs.
- Applicable Assets: The provision applies to a variety of assets including stocks, bonds, mutual funds, real estate, and other tangible properties.
- Community Property Considerations: In community property states, such as California, a double step-up in basis applies, which benefits the surviving spouse.
Step-Up in Basis for Community Property States and Trusts
In the United States, nine states operate under community property laws, where assets acquired during a marriage are considered owned jointly. In these states, upon the death of one spouse, the surviving partner enjoys a double step-up in basis, which means the entire asset’s basis adjusts to the current FMV rather than just the deceased's half.
Example in a Community Property Scenario
Consider Ann and Bill, a married couple in a community property state. They hold a joint stock account valued at $200,000 with a basis of $100,000 at the time of Bill's death. Under community property laws, Ann would receive the stock’s full value, stepping up to $200,000, significantly reducing her future capital gains tax if she decides to sell.
In contrast, if they lived in a common-law state, Ann would only receive a stepped-up basis on Bill's half of the asset, leading to a significantly greater tax liability upon future sale.
The Debate and Criticism Surrounding Step-Up in Basis
While step-up in basis provides substantial tax benefits, especially to wealthier families, it has faced criticism and is considered a loophole by some policymakers. The Congressional Budget Office (CBO) reported that a significant portion of the benefits derived from this provision accrue to the top 5% of earners. The estimated cost in lost tax revenue over a decade has been around $110 billion.
Legislative Efforts to Amend the Provision
Although there have been discussions around limiting or abolishing the step-up in basis, such efforts have not yet come to fruition. Notably, a 2021 proposal by the Biden administration to eliminate the step-up for assets exceeding $2.5 million was rejected by Congress, demonstrating the political complexities surrounding this issue.
Understanding the Calculation of Step-Up in Basis
Calculating the step-up in basis is relatively straightforward. The basis is adjusted to match the FMV of the asset on the date of the decedent's death. If the asset is later sold, the new higher basis will be used to calculate any capital gains taxes owed.
Example Calculation
If a home purchased for $200,000 is worth $500,000 at the time of the owner’s death, the basis steps up from $200,000 to $500,000. If the heir sells the home for $550,000 later, only a capital gains tax on the $50,000 gain would be applicable, compared to a potential tax on a $350,000 gain had the basis not been adjusted.
Conclusion
Understanding the step-up in basis can significantly affect tax liabilities for heirs. Although it provides beneficial tax reduction opportunities, especially for larger estates, it also stirs debate over wealth inequality and tax fairness in the U.S. As such, individuals and families planning their estates should carefully consider how this provision impacts their financial situation, and they may benefit from consulting with a tax advisor or estate planner for tailored advice.