#46 - Step-Up in Basis Explained: A Simple Guide for Families
Reluctant Executor News
The last thing that families want to think about after a death is the other certainty quoted by Ben Franklin - taxes. But when it comes to inherited property, not understanding the step-up in basis rule could cost heirs far more than they expect. The good news? With the right planning, this rule often reduces or even eliminates capital gains tax on inherited assets.
Let's back up. When you sell an asset, in most cases you will owe taxes on the gain, which is the difference between the amount you sold the asset for and the amount you paid for it. But there are special treatments by the IRS if someone dies while owning an asset. This treatment can reduce or eliminate taxes owed by the heirs.
In this post we'll explore how the step-up in basis works for different types of heirs and assets, how to keep good records, and explain covered vs. non-covered shares. As always, this post is for information only and presents a simple view on the topic. Consult a tax professional for details on your specific situation.
Full vs. Half Step-Up
The first thing to understand is if you'll receive full or half step-up. Full step-up means that the basis will be reset to the fair market value of the asset on the day of death. Half step-up mean that the asset receives only half of the step-up.
To illustrate this, imaging you and your spouse purchased $100,000 worth of stock, and it's valued at $200,000 on the day your spouse dies. If you receive full step-up in basis, the new basis becomes $200,000. This means taxes would only be paid on the amount gained over $200,000. If you receive half step-up in basis, the new basis is $150,000.
Full step-up occurs when an asset is passed to an heir that is not a spouse. However, a spouse can receive full step-up if they live in a community property state. This applies to assets accumulated during marriage. In common law states, assets jointly owned receive half step-up.
Asset Types
The most common assets that step-up in basis apply to are stocks and real estate, but it can be used on any asset that has a basis. Keep in mind that tax deferred accounts, like 401(k)s and IRAs do not receive step-up treatment. Other assets that can receive step-up in basis are art, collectibles, and business interests.
Step-up in basis can also apply to depreciation. An asset, such as a rental property, with depreciation can be "reset" to the fair market value on the date of death. Again, there are nuances to each specific situation, so work with a tax pro if this applies to you.
Keeping Records
For families receiving full step-up, you should be able to find the fair market value of stocks or mutual funds online. Many sites show historic stock values, so you just need to find the value on the day of death. For real estate, the safest method for determine fair market value is to conduct a formal appraisal.
For families that receive half step-up, finding the original basis can be tricky. Some situations may prevent you from having accurate records. For example, if you change brokerages without selling your stocks, the old brokerage may not transfer basis data. Or, you may have purchased paper stocks many years ago and lost the records. If you do not have accurate records for the original basis, you'll need to use a cost basis of $0.
Covered vs. Non-Covered
Records for stock transactions after 2011 are much easier. This is because the IRS required brokerage firms to report the cost basis to the IRS. Stocks generally acquired after January 1, 2011 are considered "covered," meaning that the IRS should have received cost basis information from your brokerage. Non-covered shares refer to shares purchases prior to 2011. Your own record keeping is crucial to ensure accurate basis reporting if you hold shares from this time.
Estate Organization
If you live in a common law state and expect to inherit assets from your spouse, knowing the original basis of your assets can help save a lot of money. Calculating the half step-up in basis isn't difficult, but it adds extra complexity during an already stressful time. During my Estate Organization meetings, we'll discuss how step-up in basis could impact you. I help you gather the information needed to quickly calculate the step-up in basis if you ever need it, instead of scrambling for it or being surprised by a high tax bill.
When you're ready to set aside time for this meeting, schedule a call with us.