You’ve diligently saved, invested, and watched your assets grow. But as you plan for the future, have you considered how those assets are taxed when they pass to your heirs? A critical yet often misunderstood tax provision known as “step-up in basis” can significantly impact your beneficiaries’ financial well-being.
This powerful rule allows inherited assets to receive a new cost basis, potentially saving your loved ones from a substantial capital gains tax burden. It’s a key difference between gifting assets during your lifetime and transferring them upon your passing.
Let’s explore what the step-up in basis rule means for your beneficiaries and how it can optimize your wealth transfer strategy.
Deconstructing “Basis”: Your Asset’s Cost for Tax Purposes
Before diving into the “step-up in basis” rule, it’s essential to understand “basis.” Simply put, an asset’s basis is its original cost for tax calculations.
This usually includes the purchase price plus any acquisition costs. When you sell an asset, any profit you make (the difference between the sale price and your basis) is considered a capital gain, which is typically subject to capital gains tax.
Example 1: Selling During Your Lifetime
Let’s say you purchased 1,000 shares of XYZ Growth Fund back in 2005 for $25 per share, totaling an investment of $25,000 (your basis). Today, those shares are worth $125 per share, making your investment worth $125,000.
If you decided to sell these shares today, you would realize a capital gain of $100,000 ($125,000 sale price – $25,000 basis). This $100,000 gain would be subject to capital gains tax and any applicable state taxes.
The Game-Changer: Step-Up in Basis
Now, consider the power of the step-up in basis. This unique tax rule applies to assets inherited after the original owner passes away. Instead of the beneficiary inheriting the deceased’s original cost basis, the asset’s basis is “stepped up” to its fair market value (FMV) on the date of the original owner’s death.
Example 2: Inheriting With a Step-Up in Basis
Using our same XYZ Growth Fund shares example: You still own the shares you bought for $25,000, and they are now worth $125,000. Instead of selling them, you pass away, and your child inherits these 1,000 shares.
Thanks to the step-up in basis rule, your child’s new cost basis in those shares immediately becomes $125,000 (the fair market value on your date of death).
If your child then chooses to sell those shares for $125,000, their capital gain calculation looks like this: $125,000 (sale price) – $125,000 (new, stepped-up basis) = $0. Your child would owe virtually no capital gains tax on the $100,000 of appreciation that occurred during your lifetime.
What Assets Qualify for the Step-Up?
The step-up in basis generally applies to most appreciated assets that are part of your taxable estate when you pass away. This includes:
- Individual stocks and bonds: Greatly appreciated securities held in non-retirement brokerage accounts are prime candidates.
- Mutual funds and exchange-traded funds (ETFs): Similar to individual stocks, ETFs held in taxable accounts qualify.
- Real estate: Homes, rental properties, and land held outside of retirement accounts generally qualify for a step-up, which can significantly reduce capital gains taxes for heirs when the property is sold.
- Other personal property: Valuables like art, collectibles, antiques, and jewelry can also receive a step-up in basis if their value has significantly increased.
Gifting Assets vs. Inheriting: A Critical Tax Distinction
The step-up in basis rule creates a stark contrast between gifting appreciated assets during your lifetime and having beneficiaries inherit them.
- Gifting assets during life (carryover basis): If you give an appreciated asset (like shares of stock) to a loved one while you’re alive, the recipient typically takes on your original cost basis. This is known as a “carryover basis.” If they later sell the asset, they are responsible for capital gains taxes on all the appreciation from your initial purchase price. This can result in a much larger tax bill for your loved ones.
- Inheriting assets at death (step-up in basis): Assets inherited after your passing gain from the step-up in basis rule, effectively resetting the cost basis to the fair market value at the time of your death. This eliminates the capital gains that accrued during your ownership period, significantly reducing or even eliminating the tax burden for your heirs upon sale.
This distinction highlights why, for greatly appreciated, non-retirement assets, it’s often far more tax-efficient for your beneficiaries if these assets are passed on through your estate rather than gifted during your lifetime.
Seek Professional Guidance
By proactively incorporating the step-up in basis rule into your financial strategy, you can empower your loved ones, mitigate unnecessary taxes, and leave a more impactful and financially sound legacy for years to come.
At Tranquility Path Investment Advisors, we want you to enjoy a sense of stability and confidence knowing your legacy plans are in place and aligned with your financial goals and values. This helps you leave a positive impact on the world without worrying about the potential financial consequences of suboptimal decisions or unexpected events.
Schedule a no-obligation conversation or reach us at (908) 759-6322.
