What is Step-Up in Basis & Why is it Important?
This article is not tax advice and the discussion herein is oversimplified to relay the concept of step-up in basis. Your individual situation should be reviewed by your attorney and tax professional.
There has been a lot of discussion in Congress about what, if anything, should be done with the income tax code to address step-up in basis. Step-up in basis is a concept that affects beneficiaries who liquidate the assets of a person who passes away (“Decedent”). Not many people know or understand what step-up in basis is, but the proposal to eliminate step-up in basis should concern anyone who is doing an estate plan and has capital assets.
The concept of step-up in basis is actually quite simple. A trust or estate and its beneficiaries, or payable on death beneficiaries, get a step-up in basis to fair market value of the asset so received. That value is stepped up to the fair market value of the asset as of the date of death of the Decedent. This is true even if the beneficiary of the asset so transferred is a spouse of the Decedent.
To break that down, if Dad owns a piece of property that is worth $500,000 and he paid $100,000 for the property, he has a tax basis of $100,000 for the home. If Dad sells the property during his lifetime, he would pay taxes on the gain in the difference between what he paid for the property ($100,000) and what he sold it for ($500,000). So, he would have income of $400,000. Under the current tax law, if he held that asset for more than one year, the gain would be treated as a capital gain.
Now, if Dad passes away and leaves the property to me, I would get a step-up in basis, as of the date of Dad’s death, to fair market value. If I now go and sell the property for $500,000, I have zero gain on the sale. My basis was “stepped up” to the value of the asset as of the date of death.
Take an asset that the Decedent has depreciated. Dad owns a 4-family apartment building that he bought for $1,000,000; $250,000 of that purchase was attributable to land and $750,000 was attributed to the building. Over 40 years, Dad depreciated the building so that building now has no depreciation left. Depreciation is a book entry allowed by the IRS that allows you to deduct the “loss” of the value over time. At the time of acquiring the property, the depreciation was 37.5 years, or in our case $20,000 per year ($750,000/37.5 = $20,000). If the property is now worth $2,000,000 and Dad wants to sell it during his lifetime, he would have a basis of $250,000 and a taxable gain of $1,750,000, or the $2,000,000 less the basis of $250,000.
Now, if I inherit that same property after Dad passes away and I sell it for $2,000,000, I would recognize no taxable gain because I get a “stepped up” basis to the fair market value of $2,000,000. If I hold onto the property, I can begin a new depreciation based on the new value.
As mentioned above, spouses of Decedents also get a step-up in basis when their wife or husband passes away.
Why is this important? Let’s say you are a married couple in your 80s and you are working on your estate plan. You are deciding what to sell and what to keep. Certainly, you want to sell assets that have a high basis to minimize your income taxes. And, you want to hold assets with a low basis to allow the survivor of you to have a full step-up in basis to fair market value on one of you passing away.
In short, if the step-up in basis is eliminated, beneficiaries receiving assets will have to pay full income tax on assets received where they generally do not have to under the current tax code.