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What Is A Step Up In Basis And How Can I Get One To Reduce My Taxes?

6-Minute Read
Published on February 17, 2021
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A step up in basis allows an individual’s heirs to readjust the value of an asset that they have inherited to match the value of the asset on the date of the original purchaser’s death for tax purposes. (As opposed to the date on which the asset was first purchased by the previous owner.)

Serving as a substitute for the original purchase price, it effectively resets the base value of the asset so that an heir can minimize capital gains tax when the asset is sold. If a step up in basis happens, it typically allows you to avoid paying tax on a larger sum (as assets purchased years ago may have since greatly increased in value). If one does not occur, the receiver must instead pay tax on capital gains based on the asset’s original value, which can often lead to larger expenses.

Put simply: A step up in basis helps ensure than an heir is only responsible for paying taxes on the amount of appreciation on an asset that occurs between the date of the bequeathing party’s death (in other words, when they receive it) and the date on which the heir sells the asset.

What Is A Step Up In Basis?

Think of it this way: Say a family member passes on and leaves you shares of stock valued at $1,000 based on their original purchase price. If these same shares of stock were instead worth $1,500 today, and you chose to sell them at this price, you’d be liable for paying capital gains tax on the $500 profit. However, if instead a step up in basis were applied to adjust these shares of stock’s value to match today’s valuations, it would effectively appear for tax purposes as if you had purchased the assets yourself for $1,500. Under these circumstances, if you chose to sell this chunk of stock, you wouldn’t be liable for paying capital gains tax on any proceeds, as the stock’s valuation and sales price would for all intents be one and the same.

At its most basic level, a step up in basis changes the value of an asset to help you readjust and recalculate tax liability – and serves as a helpful vehicle through which to help minimize the tax burden association with an inheritance. Such a tool can be especially helpful when dealing with residential properties and other forms of real estate, which (though often costly to begin with) can greatly appreciate in value over time. The step up in basis rule essentially enables you to process accounting and balance your books as if the value at which a property was purchased was the same as its value on the day you inherited it.

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What Is Capital Gains Tax? 

There are many ways as a modern professional to earn income, not all of which are related to one’s day job. For example: One way might be through investment in equities such as stocks and bonds, while another common way is to buy property, hold this property until it appreciates, and then sell it.

Long-term capital gains (applied to holdings that you’ve kept in your portfolio for 1 year or more) are taxed at either 15% or 20%, depending on your individual tax bracket. Short-term capital gains are instead taxed as if they were ordinary income. Under each of these scenarios, a step up in basis can help you keep more money in your pocket.

To calculate how much income you have generated through capital gains on an individual basis through the sale of any given asset, simply subtract the original purchase price of an asset from its sales price.

Sale Price – Purchase Price = Income

By way of a simple example, say Taylor purchased a home many years ago for a cost of $250,000. But when she passes on, and leaves it to Zoe, her sole heir, who wishes to dispense with the property, the property is now worth $500,000 – today’s fair market value. Using the step up in basis rule, if Zoe were to sell the property for $550,000 or $600,000, she would only pay capital gains tax on $50,000 or $100,000 of income derived from the sale of the home, respectively.

Is Step Up In Basis A Tax Loophole?

The short answer: No, it’s a perfectly legal and acceptable tax strategy. While some individuals may feel that it’s unfair to buy an asset, enjoy an income stream from the asset, then leave it to an heir who can avoid paying any taxes whatsoever on the asset’s appreciation, bear in mind, a step up in basis is a normal and routine financial practice that thousands of individuals capitalize upon every year.

Step Up In Basis FAQs

Many frequently asked questions (FAQs) arise when dealing with a step up in basis. You’ll find answers to today’s most common queries below.

How Does Step Up In Basis Work In Community Property States?

Individuals who reside in community property states may be able to enjoy the step up in basis twice over. Case in point: Upon the death of a spouse, the remaining partner is eligible to receive a step up in basis. Likewise, any of the surviving spouse’s heirs can also receive a step up in basis upon the death of the last remaining spouse.

For example: Say Bob and Lynn bought a home together for $150,000 in 1956. When Bob passed away from old age in 2015, Lynn received a step up in basis to reflect the home’s current fair market value of $300,000. However, upon Lynn’s death years later in 2021, her sons Albert and Harold in turn found that the home’s value had increased to $550,000 – which then became their cost basis. As you can see, a step up in basis can provide significant cost savings.

How Does A Step Up In Basis Work With Trusts?

A step up in basis works the same under the terms of a revocable, or living, trust (the kind that the grantor continues to control) until the conditions of the trust are satisfied and the property passes to an heir after the original purchaser’s death. However, irrevocable trusts function differently, and work in various ways depending on the type of trust established (e.g. grantor vs. non-grantor.) Those interested in pursuing a revocable trust are advised to speak with a qualified professional such as an attorney who specializes in trusts and estate planning.

How Does A Step Up In Basis Work With Opportunity Zones?

In 2017, the Tax Cuts and Jobs Act created opportunity zones (economically challenged areas which come with tax incentives attached to any investment made within them). Under its terms, a step up in basis can be used as an incentive for still-living real estate investors to encourage them to invest in these historically economically distressed areas. In effect, if you have made a profit on the sale of stock, property, or another asset and wish to defer capital gains taxes for a number of years, you can do so by investing in these areas.

Hold your investment within them for 5 years, and your basis is stepped up by 10%; hold it for 7 years, and it’s stepped up by 15%; or hold it for 10 years, and any investment gains from your opportunity zone investment become permanently free from capital gains taxation. As you might imagine, this provision provides a handy way to enjoy significant tax savings, especially if you’re contemplating receiving sizable gains on the sale of an asset.

When It Comes To Taxes, It Truly Is Better to Bequeath Assets

Qualified stocks, real estate, and capital assets left to your heirs provide an opportunity for you to have their original cost basis wiped out, and for these assets to be revalued at their fair market value on the date of the inheritance. Noting this, it’s not uncommon for appreciating assets such as stocks, mutual funds, and real estate to successfully continue providing for your family long after your lifetime. Should these individuals ever elect to sell the assets that they’ve received on your passing, these assets will be taxed based upon current fair market value – not the original cost – potentially leading to thousands, or even tens of thousands, in tax savings. Which, of course, can provide them with significant windfalls of their own in turn.

To learn more about taxes and insurance, or other helpful cost-saving strategies, be sure to visit our Learning Center.

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