Step Up in Basis at Death: Essential Guide for Inherited Assets

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Step Up in Basis at Death: Essential Guide for Inherited Assets

loss of a loved one

The step up in basis at death is an important provision within the tax code 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 tax code rule that resets the value of an inherited asset to its fair market price at the time of the decedent’s death.  The Internal Revenue Service (IRS) plays a crucial role in determining this fair market value, facilitating the calculation of taxes on estates and gifts.  This change creates a new basis for tax purposes. 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 a person inheriting high-value assets, as it significantly mitigates the capital gains taxes owed upon sale.

Example of Stepped Up Basis

If a property bought for $100,000 is worth $500,000 at the time of the owner’s death, the heir’s new basis becomes $500,000. If the property is sold for $550,000 later, the heir’s capital gains taxes would be owed only on the $50,000 increase, not the $450,000 increase from the original purchase price.

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 on the sale of the inherited asset.

Assets That Qualify for Step Up in Basis

The tax code allows a wide range of assets to qualify for a step-up in basis. Eligible assets include:

  • real estate
  • stocks
  • artwork
  • bank accounts
  • business interests
  • investment accounts
  • personal property

Exceptions to the Step Up in Basis Rule

Retirement Accounts and Basis Step Up

Retirement accounts, such as 401(k) plans and traditional IRAs, are notable exceptions to the step-up in basis rules. As a result, these accounts may trigger a significant tax burden for the beneficiaries, especially if the account holds substantial assets.

Additionally, the SECURE Act of 2019 introduced new rules for taxation of 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 taxation of the 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.

Gifts and Basis Step Up

Another key exception to the basis provision is when property is gifted during the giver’s lifetime. In such cases, the recipient retains the original owner’s cost 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 in the future.

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 gain 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

farm

“Special use valuation” may apply to certain farms or closely held businesses, affecting the step-up basis calculation. This tax code provision allows the farm or business 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 taxes.

An example of special use valuation is to value a farm based on its current agricultural use, rather than the future value of the redeveloped land.  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 taxes.

Valuations After Death

Proving the new basis after the original owner’s death is important for determining the tax implications of inherited assets. The fair market value of appreciated property 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

house

Accurate valuation of inherited real estate is important for establishing the step-up basis for tax purposes.  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.

Obtaining a thorough appraisal report can provide a solid foundation in case of any disputes with the Internal Revenue Service 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.

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

married couple

The step-up in basis rule is particularly beneficial for married couples 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.

Estate Planning and Basis Step Up

Estate planning is the process of organizing your affairs to ensure your assets are managed and distributed according to your wishes after your death or during incapacity. It is not just about writing a will—it’s about creating a comprehensive plan to preserve wealth, minimize taxes, and reduce burdens on your loved ones. At its core, estate planning is about protecting your legacy.

A key component of estate is the step-up in basis rule, which can significantly impact the tax implications for your beneficiaries. The step-up basis can be integrated into comprehensive strategies tailored to estate planning clients’ unique goals, ensuring wealth transfers are not only efficient but also aligned with their long-term wishes.

Equalizing Inheritances

One of the challenges in estate planning is ensuring fairness among heirs, especially when different types of assets are involved. For example, one child may inherit appreciating assets, like real estate or stock portfolios, while another receives liquid assets, such as cash or bonds. In the absence of careful planning, the child inheriting appreciating assets could face a significant tax burden when selling those assets, potentially making the inheritance inequitable.

By leveraging the step-up in basis, we can eliminate this disparity. When the basis of appreciating assets is adjusted to their fair market value at the time of inheritance, it minimizes or eliminates capital gains tax on prior appreciation. This ensures that heirs receiving property are not unfairly burdened, enabling estate planning lawyers to craft an estate plan that promotes fairness across the family.

Flexible Tool in Estate Planning

The step-up basis is a versatile element of estate planning, offering flexibility in deciding how and when to transfer assets. For instance, it is vital to determine asset retention strategies. For highly appreciated assets, it may be more advantageous to retain these assets during a client’s lifetime so that they receive a step-up in basis upon death, reducing future tax burdens for heirs.

On the other hand, selling or gifting assets during a client’s lifetime may make more sense based on the client’s goals. By evaluating the impact of a step-up in basis and optimizing these lifetime transactions, it is possible to guide clients in making informed decisions about which assets to hold, sell, or gift.

This flexibility allows estate planners to adapt plans as circumstances change, ensuring that the strategy continues to align with the client’s wealth preservation and distribution goals.

Avoiding Unnecessary Burdens

Another significant benefit of incorporating the step-up basis into estate planning is how it simplifies the process for heirs. Assets that receive a step-up in basis often pass outside of probate, especially when transferred through trusts or other estate planning instruments. This approach minimizes delays, avoids unnecessary expenses, and reduces stress for grieving family members. Streamlining the process preserves more wealth for beneficiaries and ensures a smoother transition of assets.

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. Such alterations could greatly affect estate planning and asset transfer to heirs.

What is the estate tax exemption?

Understanding the federal estate tax exemption is crucial in estate planning, as it determines the threshold above which estates must file Form 706 and potentially face tax liabilities

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Thank you to Kristen Rajagopal, Ansley Neseralla and Beckley Froebel at Bequest Law for their contributions to this article. 

Bequest Law is an Atlanta-based law firm that believes in straightforward estate planning and probate. They believe in families and in plans and in the peace of mind that comes when you combine the two.

If you are ready to cross this off your list and redefine everything you thought you knew about lawyers, call 404.500.7531, email Bequest today, or fill out the form on their home page to get started.

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For more information about the tax and accounting services provided by Massey and Company CPA, visit our Home Page!  The CPAs, Enrolled Agents, tax professionals, and bookkeepers and accountants at Massey and Company CPA are here to assist you.

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You are welcome to email Gary Massey directly at gary.massey@masseyandcompanyCPA.com.


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, estate and trust matters, IRS tax problem resolution, IRS audits, sales taxes and small business accounting and bookkeeping.  

Massey and Company CPA

Based in Atlanta and Chicago, Massey and Company CPA specializes in tax and accounting matters of small businesses, entrepreneurs, and their families.
 
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