The step-up in basis is a powerful tool in estate planning to minimize potential capital gains taxes upon death.
Inherited properties carry unique implications that can significantly impact an heir’s financial future. Understanding the concept and laws around step-up in basis becomes crucial as it influences how inherited assets are taxed. This principle allows beneficiaries to reset the cost basis of an asset to its market value at the time of the original owner’s death, which can lead to substantial tax savings.
Calculating step-up in basis isn’t as straightforward as it may seem. Various factors play a role, including the asset type and individual circumstances, making comprehension essential for effective estate planning and estate settlement.
What Is Step Up In Basis?
The Internal Revenue Code, primarily Section 1014, outlines the laws for a step-up in basis. This provision reflects a broader intent to mitigate capital gains taxes for heirs, as the tax liability is erased for gains that occurred during the decedent’s life. This law has been part of the U.S. tax code for decades, and it plays a crucial role in estate planning strategies.
A step-up in basis is a tax law provision that revalues an inherited asset at its fair market value (FMV) as of the date of the original owner’s death. When assets like stocks, bonds, real estate, and other tangible property are transferred due to inheritance, the basis of these assets—originally the purchase price—is stepped up to reflect their market value at the time of the original owner’s passing.
This adjustment can significantly reduce the capital gains taxes the heirs may owe if they sell the inherited assets, as the taxable gain is calculated based on the difference between the sale price and the updated stepped-up basis, not the original cost basis.
Assets excluded from step-up in basis include:
- Bank accounts
- Cash
- Certificates of deposit
- Retirement accounts (401(k)s, IRAs)
- Pensions
- Annuities
Like much of the United States, New York and Long Island step-up in basis laws apply at death, offering a reprieve from capital gains taxes that would otherwise be due on the appreciation of the assets over the original owner’s life.
However, New York does impose an estate tax separate from the federal estate tax, which can affect the estate planning strategies involving these assets. Leveraging the step-up in basis effectively requires careful estate planning, potentially with professional guidance, to ensure compliance with New York’s specific laws and taxation rules.
How Is Step Up In Basis Calculated? An Example
The step-up in basis is calculated by adjusting the cost basis of an inherited asset to its fair market value at the time of the original owner’s death. This means that the capital gains taxes are based on the difference between the asset’s stepped-up basis and the sale price, rather than the original cost basis.
Example: For an inherited property in Long Island, NY valued at $700,000:
If the original owner purchased the home for $300,000, and at the owner’s death, it’s worth $700,000, the heir’s new basis in the property is stepped up to $700,000. If the heir sells the property immediately for $700,000, there is no capital gains tax liability because the sale price is equal to the stepped-up basis. Assuming there is no debt on the house, the stepped up value of $700,000 will go towards the decedent’s New York and Federal estate tax limit, rather than the $300,000 cost basis.
Here’s video explanation by Leave the Key founder, Larry Wagner:
Gifting a House Prior to Death vs Passing it Down as Part of Your Estate | Appointment Recap
When Should You Apply Step Up In Basis?
The timing of when you apply the step-up in basis after someone’s death can have significant tax implications, especially in volatile markets. Applying the step-up shortly after death allows you to capture the asset’s fair market value as of the date of death – and is the most common approach and provides clarity in determining future capital gains or losses if the asset is sold soon after.
However, in some cases, it might be advantageous to wait if the value of the asset is fluctuating or expected to rise. For example, waiting 90 or 180 days may allow the asset’s value to stabilize, potentially reducing or increasing the capital gains liability if the market shifts in the heir’s favor.
It’s important to note that for estate tax purposes, the IRS allows the executor to elect an alternate valuation date, which is up to six months (180 days) after death, this is commonly known as the “6 month rule”. This can be beneficial if the asset’s value has decreased over that period, as it lowers the step-up in basis and reduces estate taxes.
Important to note: once you choose an alternate valuation date, it applies to all assets in the estate, not just individual ones. Therefore, deciding when to apply the step-up in basis requires careful consideration of both market trends and tax consequences.
Is Step Up In Basis A Tax Loophole?
The step-up in basis is often perceived as a tax benefit favoring the wealthy because it allows heirs to reset the tax basis of inherited assets to their fair market value at the time of death.
This adjustment can significantly reduce the capital gains taxes due if the assets are sold because it minimizes the taxable gain, calculated as the difference between the sale price and the stepped-up basis, rather than the original purchase price. High-value estates can seemingly utilize these tax provision laws to pass on appreciable assets like real estate and stocks with minimal tax implications, thus perpetuating wealth without the accompanying tax burden that would typically come from selling a capital asset. To offset this, large estates may be subject to State and Federal estate tax which wouldn’t impact smaller estates.
However, the counter-argument is that the step-up in basis also serves as a simplification measure within the tax code. It can be a challenge for heirs to determine the original cost basis of assets acquired long ago, particularly if the original owner didn’t keep precise records.
The step-up in basis acknowledges this reality, avoiding the potential administrative burden on both the taxpayer and the IRS and ensuring that capital gains taxes are calculated based on readily available information. Moreover, the policy applies to all levels of wealth, not exclusively benefiting high-value estates, as even those with modest assets receive a similar adjustment upon inheritance.
How Can I Use Step-Up in Basis in Estate Planning?
The step-up in basis is a powerful tool in estate planning to minimize potential capital gains taxes upon death. It adjusts the value of an inherited asset to its fair market value at the time of the original owner’s death. This tax provision can significantly reduce the taxable gain when the asset is sold by the beneficiary.
Incorporating real estate into irrevocable trusts is one strategy, as it may allow assets to receive a stepped-up basis while still accomplishing the estate planning goals of the original owner.
For tax purposes, individuals might choose to hold onto capital assets until death, knowing heirs could benefit from a step-up in basis. This contrasts with a common approach of gifting assets during one’s lifetime, where the cost basis remains at the original purchase price.
If you’re going through the probate process, consulting with a financial advisor and/or lawyers, such as a probate lawyer, will help you navigate your local market and determine which strategies to implement in your specific scenario. Leave The Key, homebuyers on Long Island, NY offers expertise in understanding how types of assets, such as real estate are impacted by the step-up basis law.
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