Step-Up in Cost Basis Explained
The Step-Up rule allows beneficiaries to increase the cost basis or “tax lots” on inherited assets and can limit capital gains tax liability. After you pass away, your beneficiary can adjust the cost basis of your investments to the market price on your date of death. This creates an incentive for elderly investors to hold appreciated assets until death instead of gifting the assets to loved ones while they are alive. In order to thoroughly understand the Step-Up rule, we need to review capital gains taxes.
Federal and State governments use multiple methods to generate tax revenue to fund annual budgets. One of these methods is the capital gains tax, a tax on the profit investors earn from growth on the sale of investments. Simply put: a capital gain is what you sold an investment for minus what you paid for it. For example, if you buy a stock for $10 and later sell it for $50, you owe taxes on the $40 profit. Now that we covered capital gains taxes, let’s learn about how the Step-Up rule can help you avoid a large tax bill.
Many people believe the Step-Up rule is an estate planning “loophole” and have scrutinized it over the years. According to Forbes.com, “Ahead of the 2016 election, President Donald Trump backed a plan that would have eliminated estate and gift taxes and liquidated step-up in basis, in addition to lowering the corporate tax rate to 15% from 35%. When it came time to pass legislation, though, the 2017 Tax Cuts and Jobs Act only cut the corporate rate to 21% from 35% and doubled the estate tax exemption. Step-up in basis survived unscathed”.
Though controversial, the Step-Up rule can help limit your capital gains tax liability. Let’s take an in-depth look at leveraging the Step-Up rule.
On 1/10/2019, Heather bought 100 shares of ABC Stock for $50 per share inside her investment account. Her cost basis for tax purposes is $5,000 (100 shares x $50 per share). On 1/5/2021, Heather passed away and her daughter Nicole inherited the ABC stock now valued at $200 per share. Due to the Step-Up rule, Nicole’s updated cost basis is $200 per share. If she sold the stock at $200 per share, Nicole would incur zero tax liability.
When you gift another individual assets while you’re alive, carryover rules apply. “Carryover” means that the new owner retains the cost basis from the original owner. In this example, let’s assume Nicole is in the 15% long-term capital gain bracket (the assets are held more than one year). If Heather gifted the stock to Nicole in 2020 while she was living and then Nicole sold the stock for $200 per share, she would have owed $2,250 in capital gains taxes at the federal level alone (($20,000 Fair Market Value – $5,000 Carryover Basis) X 15% cap gain rate). This doesn’t account for state taxes.
The Step-Up rule can apply to multiple generations of the same investment. For example, if Nicole were to pass away while still possessing the inherited ABC stock, Nicole’s beneficiary could adjust the cost basis to the price at Nicole’s date of death.
What if I hold assets Jointly?
The above example was based on an individual taxable account. For assets that are held Jointly (JT TEN), the surviving spouse is eligible for a half Step-Up. This means that if you purchase a stock for $10 and at the date of death of the first spouse, the stock is worth $30, the surviving spouse’s new basis would increase to $20 (see calculation below).
Formula: (Fair Market Value at Date of Death + Old basis) / 2 = New Basis for surviving spouse
($30 + $10)/2 = $20 new basis for surviving spouse
THE BOTTOM LINE
It’s important to note that while the Step-Up rule helps avoid capital gains taxes, it doesn’t help avoid estate taxes. Estate taxes are imposed on property valued at over $11.4 million for an individual and $22.8 million for a married couple. We recommend speaking with an attorney or financial advisor to position your investments accordingly.
If you have any questions, please reach out to us below!
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