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Step-Up In Basis: What Is It And How Can I Get One?

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Published on February 17, 2021
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Receiving an unexpected windfall is usually an exciting thing. However, it can be confusing and very stressful when it comes from an inheritance from a deceased loved one. The deceased likely worked hard to leave a legacy to you, so you want to make sure you do right by them and preserve the value of the assets.

But unfortunately, capital gains taxes can bite off a big chunk of the bequest. Fortunately, a step up in basis can drastically minimize your tax bill and preserve more of the value of the assets after their passing.

To reduce the amount you own in taxes, here’s what you need to know about a step-up in basis.  

What Is Step Up In Basis?

Step up in basis occurs when the value of inherited assets readjust in value for tax purposes. Although commonly confused as a tax loophole, a step up in basis is a legal and commonly used tax strategy in estate planning that allows owners to leave capital assets to an heir who can avoid paying taxes on its appreciation.

Suppose your grandmother left you a piece of land she bought for $50,000. When she dies, you inherit the property, and it's now worth $150,000. In this case, you can receive a step up in basis between $50,000 and $150,000.

That said, if you choose to sell the land, it will reduce your cost basis or capital gains tax. So, you will pay capital gains taxes only on the difference between the fair market value price of $150,000 and the sale price of the property.

In other words, you won't have to pay capital gains taxes on the difference between her purchase price of $50,000 and today's value of $150,000. Using a step up in basis can drastically lower your tax bill when it comes time to sell the property.

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What Is Capital Gains Tax?

To fully appreciate the benefits of a step up in basis, it is critical to understand capital gains tax. You pay the capital gains tax on an asset that's worth more when you sell than when you bought it. Essentially, you pay capital gain tax when an asset's fair market value (FMV) is greater than the original purchase price. The FMV of an asset is the price it would sell for on an open market.  

For example, let's say you bought a stock for $1. When you decide to sell the stock 2 years later, its FMV is $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. You will be taxed at the short-term capital gains rate when you hold an asset for less than a year. 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 either 0%, 15% or 20% (depending on your income and filing status). It’s worth noting that inherited property is always treated as a long-term capital gain opportunity. 

FAQs About Step Up In Basis

The concept of step up in basis seems simple enough to understand, but the tax law rules and guidelines are often complex. For this reason, it’s wise to enlist the help of a financial advisor or tax professional who can help guide you through the transaction. This way, you can identify the benefits or tax consequences of selling an inherited property before getting stuck with a costly tax bill.

How does a step-up in basis work with trusts?

Revocable and living trusts allow the grantor (the trust owner) to control the trust until the trust terms are fulfilled. Then, the property goes to the beneficiaries after the grantor’s death. Step up in basis typically operates the same way as stated above.

However, when it comes to irrevocable trusts, step up in basis may work in several ways since the method will depend on the structure and type of trust. For example, grantor trusts have different guidelines than non-grantor trusts. 

Before you establish a trust, it's wise to speak with a financial advisor and estate planning attorney to guide you through all the ins and outs of establishing a trust. Partnering with professionals makes sure your trust fulfills your wishes after your passing and abides by the federal and state laws. 

How does a step-up in basis at the death of a spouse work?

A step up in basis at the death of a spouse means the surviving spouse will inherit both ownership portions of the assets and have a chance to give their heirs a step-up in basis for their assets as well. Keep in mind that the laws may differ depending on whether you live in a community property state or non-community property state.

If you live in a non-community state, spouses act as joint tenants with rights of survivorship (JTROS). This means that when your spouse passes away, you can use the step-up in basis for one-half of the property. The deceased spouse will absorb the other half into their estate at the appreciated value.  

On the other hand, community property states let the surviving spouse apply a step-up in basis to both halves of ownership. Therefore, if the surviving spouse decides to part with the property and sells it, they can minimize their capital gains taxes. 

The Bottom Line

Losing a loved one is painful. Receiving an inheritance in the midst of it all can be confusing and stressful, and can blur your judgement when it comes to making the best financial decisions with the inherited assets. On top of that, capital gains taxes can eat away at the legacy your loved one left behind.

For this reason, understanding the tax rules such as the step up in basis strategy can help you get the most out of your inheritance and minimize your tax bill when you’re ready to sell the assets. You may also want to consult with a financial advisor who can help you navigate the ins and outs of your inheritance. 

And, if you want to learn more about inheritance and estate planning, check out our Learning Center to learn more about living trusts.

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Headshot Ashley Kilroy

Ashley Kilroy

Ashley Kilroy is an experienced financial writer. In addition to being a contributing writer at Rocket Homes, she writes for solo entrepreneurs as well as for Fortune 500 companies. Ashley is a finance graduate of the University of Cincinnati. When she isn’t helping people understand their finances, you may find Ashley cage diving with great whites or on safari in South Africa.