What is the Step-Up? It saves you & your heirs a big income tax bill
You may have heard of something called the “step-up in basis” which occurs upon the death of a U.S. taxpayer but, unless you are in the tax and/or estate planning profession, you may not have a clear understanding of that somewhat esoteric phrase. This article is intended to remedy that situation.
Let’s review for a moment. Tax basis, also known as cost basis, is what the IRS considers you paid for an asset. When you sell that asset and it has increased in value, an appreciated asset, you will owe federal capital gains taxes on the difference between the cost basis and the value of the asset on the date you sell it.
When an individual gifts an asset to someone else, the gift’s cost basis becomes the recipient’s cost basis. When the recipient sells the asset, they will owe capital gains taxes on the difference between the giftor’s tax basis and the sales price of the asset.
But when someone dies and leaves an asset to an heir, under U.S. tax law the cost basis of that asset adjusts to the value of the asset on the decedent’s date of death. Typically, that results in an increase or “step-up” in the cost basis. The step-up in basis frequently provides surviving spouses and heirs with savings or even avoidance of capital gains taxes when the asset is sold. This can be of significant benefit when seeking to transfer family wealth inter-generationally.
Here is an example of how the step-up in basis income tax law works. A married couple living in Nevada, a community property state, has assets with a fair market value of $10,000,000. Acting on advice from their attorney and wealth management advisor, the spouses established and properly titled their assets in the name of their family trust, the Mr. and Mrs. Smith Family Trust. The Smith Family Trust holds the couple’s investment accounts of $5,000,000, rental real estate worth $1,000,000, residence worth $3,500,000, and personal property such as vehicles, jewelry, and antiques of $500,000. The cost basis of the trust assets is. $5,000,000.
Shortly after the creation and funding of the trust, Mr. Smith dies in a skiing accident. During the estate settlement process, the cost basis of the assets in the Smith Family Trust were adjusted or stepped-up to the fair market value of the assets on Mr. Smith’s date of death to $10,000,000.
If Mrs. Smith decides to sell their home shortly after Mr. Smith’s death, she will pay little or no capital gains income tax on the sale after deducting all costs associated with preparing the home for sale. And in the future, securities sold in the Smith Family Trust investment account will result in lower tax bills on the sales of appreciated assets, because they will enjoy a stepped-up, higher adjusted cost basis.
Considerations in planning for the step-up in basis and other estate planning matters:
Be careful how you hold and title assets. Some couples may choose to hold assets in Joint Tenancy with Right of Survivorship rather than in a family trust. In that circumstance, the couple’s assets may receive only a 50% step-up of the cost basis at the death of the first spouse to die. For example, Mr. and Mrs. Jones have an investment account with a fair market value of $1,000,000 and a cost basis of $500,000. Mrs. Jones dies after being bitten by a rattlesnake. The couple’s investment account will receive only a 50% step-up in basis in this account.
Essentially, the decedent’s share (Mrs. Jones’s share) receives a step-up in basis of $250,000 while the survivor’s share (Mr. Jones’s share) is not adjusted leaving his cost basis at $250,000. The stepped-up cost basis at date of Mrs. Jones’s death is now $750,000, not $1,000,000 if the account were held in a family trust that would allow the full 100% step-up in basis. Upon sale of the investment account securities, the survivor will owe significantly higher income tax. It is important to be aware of and take advantage of these step-up income tax rules to avoid jeopardizing the tax significant benefits the surviving spouse and for the heirs.
In many cases, family assets should be owned and titled in a family trust. This protects the family’s privacy and avoids the expensive and inefficient probate process. If some assets are not transferred into the family trust, they may be subject to probate’s public scrutiny, high legal fees, and delays in transferring assets to the heirs.
Sometimes an asset of the decedent’s, such as real estate, is worth more on the decedent’s date of death than when it was sold shortly thereafter. For example, a piece of real property was valued at $1,000,000 when Mr. South died. Nine months later, that same piece of property was sold for $800,000, resulting in a loss of $200,000 in South family wealth. To add insult to injury, the IRS may consider the asset value at $1,000,000 per the decedent’s Estate Tax Return and require the family to pay estate tax on the $200,000 loss in value. Currently, that estate tax would be 40% or $80,000. This situation occurred frequently during the great recession 2008 to 2010 time frame. There are strategies to minimize this tax threat.
The step-up in basis rule can be extremely beneficial for surviving spouses and heirs which is why it is critical that families plan well and avoid possible traps and pitfalls. The step-up rule helps protect your wealth and your heirs wealth. To learn more about best practices to preserve your nest egg, see our blog article at https://www.rswwealth.com/blog/how-long-will-your-retirement-nest-egg-last-will-you-be-able-to-leave-a-legacy-to-your-family/
We welcome your comments on this topic and offer a complimentary meeting to discuss your questions on these important tax and wealth management plans.
This article is for informational purposes only and is not to be construed as investment or tax advice. Readers are strongly advised to consult with their professional advisors before attempting to employ any concepts stated herein.