(get ready for a whirlwind tax lesson!)
A basis step-up is one of the basic concepts of estate planning. When a person dies, we say that their assets get a “step-up” in basis. Basis is short-hand for “income tax basis,” “tax basis,” or “cost basis” and is often shortened simply to “basis.” The general rule is that basis is what you paid for the asset. A step-up in basis means that when the heir inherits the property, for tax purposes it is as if the heir purchased the property on the person’s date of death—thus the assets get a step up in tax basis from the original purchase price to the price on the date of death. Let’s illustrate with some examples.
Dearly departed Auntie Em
Auntie Em bought a share of Boeing stock for $25 in 2002 and she died in September 2017 when it has a value of $240. You—Dorothy—inherit. Your tax basis is $240: you received a step-up in basis from $25 to $240 due to her death. The capital gain earned during her life is forgiven, disappears, poof. Auntie Em’s basis was $25 (what she paid for it) and if she sold it in August, she had a capital gain of $215 and will pay taxes on that. Instead, she dies holding the stock and you inherit it. You sell it for $240 and you have no capital gain. Or you hold it for a year and depending whether the stock price increases or decreases you will: [a] sell it for $250 and have a $10 capital gain, or [b] sell it for $230 and have a $10 capital loss. You get to reset the basis to market value when Auntie Em dies.
You are certainly sad that Auntie Em died but you are happy about the taxes consequences because everyone wants their gains to be high (make money), but their taxable gain to be low (pay less taxes). In the above example, if you inherit it and sell it for $240, the actual capital gain on that stock is $215 (bought at $25 in 2002 and sold at $240). But the taxable capital gain is $-0- because of the step-up in basis.
Dearly departed Uncle Henry and Auntie Em
Let’s expand on this example. Uncle Henry and Auntie Em live in a community property state, say California. Uncle Henry worked for Boeing, bought a Boeing share in 1985 for $5 and held it as “community property.” (This is an important factor.) Uncle Henry dies in 2002 when Boeing is worth $25. Auntie Em’s tax basis is now $25. She gets a step-up. She still owns that share when she dies in 2017 and you, Dorothy, inherit this share of Boeing and your tax basis is $240. In this process, the basis was stepped-up twice and in reality, the IRS lost tax revenue because of the two deaths.
The situation would be different if Uncle Henry and Auntie Em lived in Kansas (kind of fits), a common law state, and they held the stock jointly (get ready for some calculations). Only Uncle Henry’s 50% in the stock gets stepped up at his death. Bought at $5 and worth $25 in 2002. Auntie Em’s basis is now $12.50 for Henry’s part (step-up) and $2.50 for her part (no step up) to give her a tax basis of $15. I can’t make this stuff up! You have the tax code to thank. If she sells at $25 in 2002, she has a taxable capital gain of $10. However, if she continues to hold the stock and you, Dorothy, inherit the stock in 2017, we are back to you getting $240 tax basis.
Tax basis can be complex and is important in both income tax planning and estate tax planning. If you have questions about tax basis for any assets you own, even beyond stock, bond, and mutual fund holdings, please feel free to reach out to us. We’ll help you get your feet on the ground and a step up on understanding it!