What is a Step-Up Basis and How Does it Work?

What is a step-up in basis and how does it work? In this article we will discuss what a step-up in basis is, how it benefits you and what is and is not covered.

What is a Step-Up Basis and How Does it Work?

A step-up in basis refers to the adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent’s death. Cost basis, more commonly the price paid for an asset, is what determines the taxes owed, if any, when the asset is sold.

Step-up in basis, or a stepped-up basis, is what happens when the price of an inherited asset on the date of the decedent’s death is above its original purchase price. The tax code allows for the increasing of the cost basis to the higher price, decreasing the capital gains taxes owed if the asset is sold later.

The step-up in basis provision applies to financial assets like stocks, bonds and mutual funds as well as real estate and other tangible property.

Of course, if the price of an asset has declined from that paid by the owner’s date of death, the asset’s cost basis would step down instead of stepping up for heirs.

In practice, most cost basis adjustments after death are steps up, not steps down. This is because financial assets passed on to heirs are often long-term holdings, while financial assets and real estate tend to have positive long-term rates of return.

How Does a Person Benefit From a Step-Up in Basis?

With a step-up in basis, capital gain taxes are calculated on the appreciation in value of the asset from the date of their loved one’s death instead of when the asset was first acquired. Additionally, the tax is only assessed when a beneficiary decides to do something with the inherited asset (such as sell it). This protects the asset’s value, helps keep property and other assets, such as businesses, within families, and allows for unhindered transfers of wealth. In most cases, if a beneficiary inherits an asset and sells it immediately, they will owe no capital gains tax.

How Is Step-Up in Basis Treated Differently in Community Property States?

In community property states, such as Texas, (and for assets in community property trusts) the surviving spouse receives a step-up in basis for community property for any community property assets they receive. In the majority of states without community property provisions, jointly-owned property such as stock in a joint brokerage account would receive only half the step-up in cost basis compared with the same account in a community property state after the death of a spouse.

What is Not Covered?

Some assets will not get a step in basis at the death of the owner. Retirement assets held in IRAs and 401k’s do not get a step up. The money that is withdrawn from these accounts is subject to regular income tax. Assets that are held in a Bypass or Credit Trust after the death of a first spouse, will pass to the beneficiaries without a step up. All such assets did receive a step up in basis after the first spouse’s death, but, because they are held in an irrevocable trust after that death, will not receive a second step up at the second spouse’s death.

If you still have questions or need any assistance with step-up basis, contact the lawyers at The Hoggatt Law Firm and schedule your appointment today.