What Is a Step-Up in Basis?
Let me explain step-up in basis directly: it's a tax rule that changes the cost basis of an asset you inherit to its fair market value on the day the previous owner died. You need to know this because the cost basis affects how much tax you pay when you sell the asset. It begins with what the asset originally cost, plus any improvements or maintenance expenses added over time.
For you as the beneficiary, if the asset's value has gone up since it was bought, this step-up means your cost basis increases, which lowers your capital gains tax if you sell it. But if the value has dropped, the basis steps down instead, though that's rare since most inherited assets have appreciated over time. This applies to things like stocks, bonds, mutual funds, real estate, and other properties.
Key Takeaways
- Step-up in basis resets the cost basis of an appreciated inherited asset for tax purposes.
- It raises the basis to the market value on the date of death, reducing future capital gains taxes.
- In community property states or trusts, surviving spouses get a step-up on community property.
- Critics say it mostly benefits wealthy households, prompting unsuccessful reform attempts.
How Does Step-Up in Basis Work?
Here's how it operates: the step-up resets the asset's cost basis from its original purchase price to the higher market value at the owner's death. Take this example—suppose someone buys a stock for $2 and dies when it's worth $15. If they sold it before death, they'd owe tax on a $13 gain. But as the heir, your basis becomes $15, so selling at that price means no capital gains tax for you. That eliminates the tax on the growth from $2 to $15.
Step-Up in Basis in Community Property States
If you live in one of the nine community property states like California, you can use the double step-up rule. This gives a step-up for assets acquired during marriage—excluding gifts or inheritances—to the surviving spouse. In other states, assets only in the survivor's name don't get stepped up, and joint assets get just half the step-up compared to community property states.
States like Alaska, Kentucky, South Dakota, and Tennessee let you set up community property trusts for this treatment, even if you're not a resident. Consider this: a couple in a common-law state has joint stock worth $200,000 with a $100,000 basis when one dies. The survivor gets a step-up on half, making the new basis $150,000—not the full $200,000 you'd see in a community property setup.
Step-Up in Basis as a Tax Loophole
People often call this a tax loophole for the rich, and the numbers back that up—the Congressional Budget Office says over half the benefits go to the top 5% by income. In 2024, it's estimated to cost the government $58 billion in lost revenue, rising to $68 billion by 2027.
Supporters argue eliminating it could discourage saving and lead to double taxation with estate taxes, but with the estate tax exemption so high, only 0.04% of deaths in 2020 triggered it. A 2021 proposal to end step-up for assets over $2.5 million per couple didn't pass.
Frequently Asked Questions
You might wonder how to calculate step-up in basis—it's straightforward: reset the original cost to the market value at death, no complex math needed. Then, when selling, subtract that new basis from the sale price for potentially lower taxes.
In community property states, the surviving spouse gets a full step-up on shared assets, while common-law states limit it to half for joint property. Yes, it's legal, but it's criticized for costing revenue and favoring the wealthy.
The Bottom Line
To wrap this up, step-up in basis adjusts inherited assets' cost basis to fair market value at death, which can slash your capital gains taxes when you sell. It's a key tax break, but it's under fire for mostly helping the rich pass on wealth tax-free.
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