Step up in basis at death is an important key tax rule that can benefit those inheriting assets. It resets the value of inherited assets to their fair market value at the decedent’s death, reducing future taxes on capital gains. In this article, we’ll explain how this rule works, its benefits, and what types of assets qualify.

Key Takeaways

• The step-up in basis at death resets the value of inherited assets to their fair market price at the time of the decedent’s death, reducing potential capital gains taxes for heirs.

• Various capital assets, including real estate and stocks, qualify for the step-up in basis, while exceptions exist for certain retirement accounts and gifted property.

• Proper valuation of inherited assets is essential for establishing the new basis.

Understanding Step Up in Basis at Death

The step up in basis is a basis provision in the tax code that resets the value of an inherited asset to its fair market price at the time of the decedent’s death. This change creates a new basis for tax purposes and often benefits appreciated property. Usually, this adjustment increases the asset’s cost basis, under the assumption that fair market values typically increase over time.

This provision can be especially advantageous for those inheriting high-value assets, as it significantly mitigates the capital gains taxes owed upon sale.

Example of Stepped Up Basis

If a property originally purchased for $100,000 is worth $500,000 at the decedent’s death, the heir’s new basis becomes $500,000. If the property is sold for $550,000 later, the capital gain is the difference between the sales price and the new basis, so only $50,000 would be taxed rather than the full increase from what the property was bought for.

While not common, if the value of an asset decreases after the owner’s death, its basis steps down rather than up for the heirs. This will probably increase, rather than decrease, the tax the heir may pay tax on when the inherited asset is sold.

Alternative Valuation Date

An alternative valuation date is an option available to the executor of an estate, allowing them to choose a different date for valuing the deceased person’s assets for estate tax purposes. Instead of using the date of death, the executor can elect to use a date six months after the date of death. This can be beneficial if the value of the estate’s assets has decreased during that six-month period, potentially lowering the estate tax liability.

The alternative valuation date can only be used if it results in a decrease in both the value of the gross estate and the estate tax due. It is important to note that this election is irrevocable once made, and it applies to all assets in the estate, not just selected ones.

Benefits and Considerations

Using the alternative valuation date can provide significant tax savings for the estate, especially in cases where market conditions have caused a decline in asset values. However, executors must carefully consider the overall impact on the estate and the beneficiaries. For example, if certain assets have appreciated in value during the six-month period, using the alternative valuation date might not be advantageous.

Additionally, the decision to use the alternative valuation date should be made in consultation with tax professionals and estate planners to ensure compliance with tax laws and to optimize the financial outcomes for the estate and its beneficiaries.

Example

Consider an estate that includes a portfolio of stocks worth $1 million on the date of death. If the value of the stocks decreases to $900,000 six months later, the executor can elect to use the alternative valuation date, potentially reducing the estate tax liability. However, if the value of other assets in the estate has increased during the same period, the overall benefit of using the alternative valuation date must be carefully evaluated.

Overall, the alternative valuation date is a valuable tool for estate planning, offering flexibility in managing estate tax obligations and maximizing the financial benefits for heirs. Executors should thoroughly assess the pros and cons of this election and seek professional advice to make informed decisions.

Assets That Qualify for Step Up in Basis

A wide range of capital asset qualifies for a step-up in basis. Eligible assets include:

• real estate

• stocks

• artwork

• bank accounts

• business interests

• investment accounts

• personal property

How to Elect Basis Step Up

Electing a step-up in basis is typically an automatic process that occurs upon the death of the asset owner, requiring no specific action by the heirs. The fair market value of the inherited assets on the date of death becomes the new cost basis for tax purposes by default. However, in some cases, certain elections or actions may be necessary to optimize tax benefits or comply with specific tax rules.

Filing an Estate Tax Return (Form 706)

If the estate exceeds the federal estate tax exemption threshold, the executor must file Form 706, the United States Estate (and Generation-Skipping Transfer) Tax Return. This form reports the fair market value of the decedent’s assets as of the date of death or the alternative valuation date if elected. The values reported on Form 706 establish the basis for the inherited assets. Accurate reporting is crucial, as these valuations are used to determine the step-up in basis for the heirs.

Electing the Alternate Valuation Date

As discussed earlier, the executor can elect to use the alternative valuation date, which is six months after the date of death, if it lowers the estate tax liability. This election affects the basis of the assets reported on Form 706 and, therefore, the step-up in basis for the heirs. Once made, this election is irrevocable and applies to all assets in the estate.

Documentation and Record Keeping

Heirs should maintain thorough documentation of the asset valuations used to establish the stepped-up basis. This includes appraisal reports, brokerage statements, and any estate tax filings. Proper records will be essential when calculating capital gains taxes upon the sale of inherited property and in case of an IRS audit.

Coordination with Financial Institutions

For assets held in brokerage accounts or other financial institutions, heirs should notify the institution of the decedent’s death and provide necessary documentation. Financial institutions can then update the cost basis records to reflect the stepped-up basis, preventing unnecessary capital gains taxes if the assets are sold.

Consult a Tax Professional

Given the complexities involved in electing and documenting the step-up in basis, it is highly recommended that heirs and executors consult with tax professionals or estate planning attorneys. They can provide guidance tailored to the specific circumstances, ensure compliance with tax laws, and help maximize tax benefits.

By understanding how to properly elect and document the step-up in basis, heirs can effectively minimize their capital gains tax liabilities and ensure a smoother estate settlement process.

Exceptions to the Step Up in Basis Rule

Retirement Accounts and Basis Step Up

Inherited traditional IRAs and other retirement accounts like 401(k) plans are notable exceptions to the step-up in basis rules. These accounts are subject to different tax treatments and do not benefit from the same basis adjustment.

When an individual inherits a traditional IRA or 401(k), they are required to pay income taxes on the distributions they receive, based on the account’s value at the time of inheritance. This can result in a significant tax burden for the heir, especially if the account holds substantial assets.

Additionally, the SECURE Act of 2019 introduced new rules for inherited retirement accounts, requiring most non-spouse beneficiaries to withdraw the entire account balance within ten years of the original owner’s death. This accelerated distribution schedule can further increase the tax liability for heirs, as they may be pushed into higher income tax brackets due to the large distributions.

Trusts and Basis Step Up

Certain trusts, including irrevocable trusts and intentionally defective grantor trusts, also do not qualify for a stepped-up basis. This is because the assets held within these types of trusts are not considered part of the decedent’s estate for tax purposes. As a result, the beneficiaries of these trusts cannot benefit from the step-up in basis rule and may face higher capital gains taxes when selling the inherited assets.

It is important to understand the specific terms and conditions of each trust, as they can vary significantly and may impact the overall tax implications for the beneficiaries. Proper estate planning and consultation with a tax professional can help navigate these complexities and optimize the tax outcomes for the heirs.

Gifts and Basis Step Up

Another key exception is when property is gifted during the giver’s lifetime rather than transferred at death to a family member. Gifted appreciated property keeps carryover basis instead of receiving the same treatment as inherited appreciated property. In such cases, the recipient retains the original owner’s basis, known as the carryover basis, instead of receiving a stepped-up basis at the donor’s death. This can significantly impact the capital gains taxes the recipient must pay if they sell the gifted property later.

Example:

Jane gifts her vacation home to her daughter, Sarah, while Jane is still alive. Jane originally bought the home for $200,000, and at the time of the gift, its market value is $500,000. Since the property is gifted, Sarah inherits Jane’s original basis of $200,000. If Sarah decides to sell the vacation home later for $600,000, she will owe capital gains taxes on the $400,000 increase from the original purchase price ($600,000 – $200,000), not the $100,000 increase from the value at the time of the gift ($600,000 – $500,000). This can result in a higher tax burden for Sarah compared to if she had inherited the property and received a stepped-up basis.

Special Use Valuation for Farms and Closely Held Businesses

“Special use valuation” may apply to certain farms or closely held businesses, affecting the step-up basis calculation. This provision is particularly beneficial for family-owned farms and businesses, as it allows the property to be valued based on its “current use” rather than its “highest and best use.”

Special use valuation can significantly reduce the estate’s value for tax purposes, making it easier for heirs to continue operating the farm or closely held business without being burdened by high estate taxes.

Example:

For example, a family farm that has been in operation for generations may have a market value far exceeding its value as an agricultural property. By using special use valuation, the farm can be appraised based on its agricultural use, resulting in a lower estate value and reduced tax liability. This provision helps preserve family farms and businesses, ensuring they can be passed down to future generations without the need to sell off assets to pay estate taxes.

However, there are specific requirements and limitations for qualifying for special use valuation. Heirs must continue to use the property in the same manner for several years to maintain the special use valuation benefits. Failure to meet these requirements can result in recapture of the tax benefits, leading to increased tax liability for the heirs.

Valuations After Death

Proving the new basis after the original owner’s death is important because the fair market value at the decedent’s death is the figure used for Internal Revenue Service documentation and later tax support. The fair market value at the time of death should be carefully documented. This is important for tax calculations and in the event of an IRS audit.

Valuation of Real Estate

Accurate valuation of inherited real estate is important for establishing the step-up basis for tax purposes. Hiring a certified appraiser to determine the fair market value of the property at the time of inheritance is advisable. This valuation is crucial because heirs may not need to pay capital gains taxes if they choose not to sell the property. Capital gains taxes are only applicable on the appreciation from the date of the previous owner’s death when the inherited property is eventually sold.

The valuation process involves a detailed inspection of the property, analysis of comparable sales, and consideration of current market conditions. Appraisers may also take into account any unique features of the property, such as historical significance or special zoning regulations, which could affect its value. Additionally, obtaining a thorough appraisal report can provide a solid foundation for any potential disputes with the IRS regarding the property’s value.

Valuation of Publicly Traded Stocks and Funds

The fair market value for publicly traded stocks and funds is determined by their market prices on the date of the benefactor’s death. Check the stock prices on that specific date to establish this value.

If possible, avoid selling these assets immediately. Wait until the investment institution updates the account with the new step-up in basis.

Valuation of Private Companies and Other Assets

Valuing private companies for a new basis typically requires certified business appraisers. These professionals ensure compliance with valuation standards and accurately determine the fair market value of the inherited business interests.

The valuation process for private companies can be more complex than for publicly traded assets due to the lack of readily available market prices. Business appraisers will consider various factors, such as the company’s financial statements, market conditions, industry trends, and the overall economic environment. They may also analyze comparable sales of similar businesses and apply different valuation methods, such as the income approach, market approach, or asset-based approach, to arrive at a fair market value.

In addition to private companies, other assets such as intellectual property, collectibles, and unique personal property may also require specialized appraisals to establish their new basis. Intellectual property, including patents, trademarks, and copyrights, can have significant value and require expert evaluation to determine their worth accurately. Collectibles, such as rare coins, stamps, vintage cars, or fine art, often necessitate appraisal by specialists familiar with the specific market for these items.

Basis Step Up and Married Couples

The step-up in basis rule is particularly beneficial for married couples, especially those living in community property states. In these states, when one spouse dies, the entire property owned jointly by the couple receives a step-up in basis to its fair market value at the time of the deceased spouse’s death. This means that the surviving spouse can sell the property with minimal capital gains tax liability, as the new basis is often close to the current market value.

Community property states include Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Additionally, Alaska allows couples to opt into community property arrangements.

In non-community property states, only the deceased spouse’s share of jointly owned property receives a step-up in basis. The surviving spouse retains the original basis for their share, which can result in higher capital gains taxes if the property is sold. Understanding these differences is crucial for estate planning and tax strategies for married couples.

Example of Step-Up in Basis for Married Couples

Consider a married couple, John and Mary, who purchased a home for $200,000. They live in a community property state. At the time of John’s death, the home is worth $600,000. The entire property receives a step-up in basis to $600,000. If Mary sells the home for $650,000, she would only owe capital gains taxes on the $50,000 increase from the new basis.

In contrast, if they lived in a non-community property state, only John’s share of the property would receive a step-up in basis. Assuming they owned the home equally, John’s share would step up to $300,000 (half of $600,000), while Mary’s share retains the original basis of $100,000 (half of $200,000). If Mary sells the home for $650,000, her new basis would be $400,000 ($300,000 from John’s share + $100,000 from her share), resulting in a capital gain of $250,000.

Estate Planning and Basis Step Up

Estate planning is the process of arranging and managing your assets to ensure they are distributed according to your wishes after your death. It involves creating legal documents such as wills, trusts, and powers of attorney to protect your estate and minimize tax liabilities for your heirs. Proper estate planning can provide peace of mind, knowing that your loved ones will be taken care of and your assets will be handled efficiently. A key component of estate planning is understanding the step-up in basis rule, which can significantly impact the tax implications for your beneficiaries. Whether an estate exceeds the federal estate tax exemption also determines whether there is a taxable estate. For decisions involving inherited assets and capital gains taxes, a person should work with a financial advisor.

Summary

In summary, understanding the step-up in basis at death is crucial for effective estate planning and minimizing tax liabilities. This provision offers significant tax relief for heirs by resetting the cost basis of inherited assets to their fair market value at the time of the decedent’s death. Staying informed about potential changes to these rules and their implications is essential for making informed financial decisions.

 

Frequently Asked Questions

What is the step-up in basis at death?

The step-up in basis at death recalibrates the value of an inherited asset to its fair market value at the time of the decedent’s passing, thereby resetting the cost basis for tax implications. This adjustment can significantly reduce capital gains taxes for the heir upon selling the asset.

How does the step-up in basis affect capital gains taxes?

The step-up in basis effectively reduces capital gains taxes by adjusting the asset’s cost basis to its fair market value at inheritance, which lowers the taxable gain upon sale. This provision can significantly benefit heirs by minimizing their tax liabilities.

Which assets qualify for a step-up in basis?

Assets that qualify for a step-up in basis include real estate, stocks, artwork, bank accounts, business interests, investment accounts, and personal property. Understanding this can significantly impact the tax implications of inherited assets.

Are there any exceptions to the step-up in basis rule?

Yes, exceptions to the step-up in basis rule include inherited traditional IRAs, 401(k) plans, certain trusts, and gifted property, which do not receive this adjustment.

What are the potential changes to the step-up in basis rules?

Potential changes to the step-up in basis rules may be proposed to eliminate or modify them, reflecting criticism that they disproportionately benefit wealthy families. Critics sometimes describe the rule as a tax loophole, while supporters argue repeal could create double taxation. Such alterations could greatly affect estate planning and asset transfer to heirs. Proposals during the Biden administration also drew attention from the Joint Committee when lawmakers evaluated revenue effects.

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Thank you to Rachel Donnelly at After Light for her contributions to this article. Based in Atlanta, MyAfterLight a consulting firm that offloads the administrative tasks that come with legacy planning and after loss, so clients can focus less on the logistics and more on creating space to live worry-free and grieve peacefully.

AfterLight is a founding member of Professionals of After Loss Services (PALS), a network of industry professionals dedicated to helping individuals and families manage the unavoidable tasks and affairs that come along with losing a loved one.

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Massey and Company CPA is a boutique tax and accounting firm serving individuals and small businesses in Atlanta, Chicago and throughout the country.  Our services include tax return preparation, tax planning for businesses and individuals, estates and trusts, IRS tax problem resolution, IRS audits, sales taxes and small business accounting and bookkeeping.