What Is A Step Up In Basis And How Can I Get One?

When setting up an inheritance, taxes can be a tricky point to consider. Luckily, a step up in basis can help anyone who inherits an asset save big on tax costs.

Ready to learn more about this possible way to save on taxes? Here’s what you need to know.

A step up in basis is what happens when an asset’s cost basis is reset for the heir to correlate with the property’s fair market value (FMV) when their benefactor died.

For example, let’s say that your uncle leaves you a home that he originally purchased for $100,000. When he bequeathed the property to you, it had appreciated to a value of $250,000. With that, you would be able to enjoy a step up in basis from $100,000 to $250,000.

If you decide to sell the property, this step up in basis will greatly reduce your capital gains tax burden. Instead of paying capital gains taxes on the difference between $100,00 and the sale price, you would only have to pay capital gains tax on the difference between $250,000 and the sale price.

Depending on your unique situation, a step up in basis could save you thousands of dollars.

In order to fully appreciate the benefits of a step up in basis, it is critical to understand capital gains tax. You will pay capital gains tax on any asset that’s worth more when you sell than when you bought it.

For example, let’s say you bought a stock for $1. When you decide to sell the stock 2 years later, it is worth $5. With that, you would pay the long-term capital gains tax rate on the difference of $4.

The length of time that you hold onto the asset will affect your capital gains tax rate. When you hold an asset for less than a year, you will be taxed at the short-term capital gains rate. Short-term capital gains are taxed at your ordinary income tax level.

But if you hold onto the asset for more than 1 year, you will pay the long-term capital gain rate which can be between 0% to 20%. It is worth noting that inherited property is always treated as a long-term capital gain opportunity.

In real estate, the adjusted cost basis (ACB) is the combined value of the property’s purchase price plus any capital improvements to the property, minus the amount of any tax credits received on the property.

The tax liabilities of a property owner can change dramatically if they choose to sell before their death or bequeath it to someone. Let’s take a look at two scenarios.

Tax Liability Without ACB

Let’s say that a benefactor bought a property for $100,000 5 years ago. One week before their death, they sold the property. At that point, the estate would still be responsible for covering the capital gains taxes associated with their original cost basis of $100,000. With that, the beneficiary of their estate would owe taxes based on the original cost basis of $100,000.

Tax Liability With ACB

In this case, let’s say that the benefactor held onto the property until their death. Due to the passing of the benefactor, the heir will receive a step up in basis to the fair market value at the time of the benefactor’s death.

The heir decides to sell the property within a week of the benefactor’s passing. From the time of the benefactor’s death to the sale of the property, the value doesn’t increase at all. With that, the heir will have to pay no capital gains taxes. 

The Internal Revenue Service (IRS) chooses to use the fair market value at the time of the benefactor’s death to determine the new value of the asset being transferred to help calculate the capital gains taxation of inherited properties. With this clear distinction, the IRS can more easily assess taxes on estate and gifts.

Haven’t you heard that primary residences are exempted from capital gains tax? That is true up to a point. On the sale of a primary residence, capital gains income exemptions of up to $250,000 for an individual taxpayer or $500,000 for a married couple filing jointly apply.

For example, let’s say that a married couple purchases a home for $150,000. Ten years later, they sell the home that served as their primary residence for $300,000. With that, the capital gains from the sale of $150,000 would be tax exempt.

In another situation, let’s say that a family purchases a home for $100,000. After 100 years, the home has appreciated to a value of $3,000,000. Over the years, the house has passed from family member to family member at the time of death. After inheriting the property with the significant step up in basis, an heir could choose to sell the property to pay a minimal amount in capital gains taxes.

When you inherit a property, you may not want to sell it. Although that means that you won’t pay capital gains taxes on the sale of the property, your future heirs will enjoy the appreciation that the property builds. If your heirs decide to sell the property, under the law in its current form, this can postpone taxes for generations to come.

Whenever an heir down the line chooses to sell, the seller will only have to pay capital gains taxes on the appreciation in the property’s value from the date of their surviving parent’s death. The heir will not have to pay capital gains taxes on all the appreciation that occurred since their great-grandparents bought the property minus whatever they paid.

In the eyes of some, the step-up in basis option is a tax loophole. Essentially, the rule allows someone to pass extensive property to their heirs without paying taxes on the appreciation along the way.

With that in mind, the Biden administration has created a proposal to close this loophole within the American Families Plan. Within this plan, the newfound tax revenue is intended to fund portions of the proposed infrastructure improvements. The administration’s view is that this tax rule only benefits the very wealthy with homes that have values well above the $500,000 exemption.

If the proposal passed as is, an estate would have to pay any taxes due on the appreciation of the property’s value. For example, let’s say that someone purchased a home for $300,000. Twenty years later, the home is worth $1,000,000 while the person passes away and leaves the property their heirs. With that, the estate would have to pay capital gains tax on the appreciation of $700,000 before the heir can enjoy the stepped up basis of $1,000,000.

For now, this is only a proposal from the Biden administration. In the coming months, it may or may not become law.

The unfortunate truth is that tax laws can be difficult to understand and complicated to comply with. If you are in doubt, you should speak to your financial advisor about whether you should accept a gift of property or the tax consequences of selling an inherited property.

What if the property suddenly depreciates in value?

Let’s say that a group of siblings inherited a commercial building in midtown Manhattan in January 2020, shortly after their last parent’s death. They had planned to list the property for sale in April 2020 after completing some much-needed renovations.

In March 2020, of course, the pandemic hits, and offices across the city empty out and employees begin working from home. With that, the value of the property suddenly depreciated.

If you inherit a property that suddenly depreciates, Section 2032 of the Internal Revenue Code allows for an alternate valuation of the ACB under some circumstances. Under some circumstances, such as the one in our example, the siblings can elect to use the FMV 6 months after the death if they decide to hold onto the property.

As a group, the siblings will need to weigh the risks of holding onto the property until its value rebounds. Plus, the costs associated with maintaining a building for an extended period of time.

What about a step up in basis at the death of a spouse?

Depending on your state, you may be able to enjoy a step up in basis upon the death of a spouse.

Non-Community Property States

In every state but the community property states, spouses are treated as joint tenants with rights of survivorship (JTROS). With that treatment, you may receive a step up in basis for one-half of the property when a spouse dies. The other half of the increased value would be included in the deceased spouse’s estate.

Community Property States

If you live in a community property state, things work a little bit differently. When the first spouse dies, the surviving spouse enjoys a step up in basis to both ownership portions of the property. With that, a surviving spouse that decides to sell will save on capital gains taxes.

Capital gains taxes can be a major expense for beneficiaries. If you want to avoid capital gains taxes, then inheriting an asset is preferred to receiving any property as a gift. However, the primary residence capital gains exemption makes this decision more pressing for wealthy property owners.

Want to learn more about the tax implications of gifting? Check out our Learning Center.