The concept of step-up in basis is a staple in estate planning. Planning decisions must take this concept into account, as the potential benefits of preserving step-up in basis for your heirs is tremendous.
The step-up in basis is a method around paying capital gains taxes, which is a form of income tax.
Generally, if you purchase an asset for a certain cost, and then sell it a few years later, you will pay income tax (called capital gains), at a certain reduced tax rate, on the gains (profit) you made. So, for example, if you bought a home for $100,000 and then sold it for $350,000, you made $250,000. This is your capital gain, and you will pay tax on the gain. Combined federal and state tax in California can lead to an approximately 33% tax. (Note that under IRC 121, if the asset was used as a personal residence by the seller for two of the previous five years, the first $250,000 of gain will likely be exempt from capital gains tax but any additional gain would be subject to the tax).
However, if you inherit the house from your father when he died, and then you sold it, the result is different. In this case, when your father died, his cost basis (the price he paid for the home, $100,000) “steps up” to fair market value on the date of his death ($350,000). So, assuming you sell the home for $350,000, there is no capital gain ($350,000 less $350,000), and therefore no tax.
Therefore, it is better to inherit a property and then sell it, in order to remove the capital gains from the asset.
Gifting Leads to Carry-over Basis
Transfers that are made in lifetime to a child, for example, are taxable gifts. More importantly, gifts carry with them the donor’s basis in the property. This is called “carry-over” basis.
For example, if your father gifted a property to you (or added your name to the deed), he has made a taxable gift to you, but more importantly, you are inheriting from your father the basis he had in the property ($100,000, the purchase price, assuming no adjustments for depreciation or improvements). Now, when you sell the property at $350,000, you will still pay the same tax he would have, because the step-up in basis will not apply to you, even at his death, as you were added in lifetime and you retained your father’s “carry-over” basis.
For this reason, you should never add your children to title because by doing so, you are gifting them your carry-over basis and removing the possibility of them to take advantage of a step-up in basis at your death. (Click the link to read other reasons why adding a child is usually a bad idea).
Joint Tenancy vs. Community Property
One question that comes up here is: if you are married and jointly own the property, should you own the property in community property or joint tenancy? That depends if you live in a community property state like California.
If so, let’s start with the following assumptions:
- You bought land as an investment in 2000 for $40,000. This is called your BASIS. Your basis is $20,000 and your spouse’s basis is $20,000.
- Today, it’s worth $220,000. Your share of the property is $110,000 and your spouse’s share is $110,000.
But, if you died, and your surviving spouse then sold the land, step-up in basis works differently depending on whether the property was owned as joint tenancy or community property.
Step-up with Joint Tenancy
At your death, your basis (which was $20,000) “steps up” to your share of the fair market value ($110,000). Your spouse’s basis remains the same ($20,000). (See IRC 1014(b)(9)). Therefore, the total basis in the property is $130,000.
So if your spouse sells the property, under joint tenancy, the capital gain would be $90,000 ($220,000, the sale price, less the basis, $130,000). Taxes would be owed on the $90,000 of gain.
Step-up with Community Property
If the title is held as community property though, step-up has even more benefit. Not only does your basis step-up at death, but so too does the basis of your spouse, even though your spouse is still alive. (See IRC 1014(b)(6)).
Thus, the capital gains in a community property arrangement would be $0 (because the revised basis would step up completely to $220,000).
This boost to the step-up in basis under community property is sometimes referred to as a “double step-up in basis.” It is available in community property states like California.
No Step-up in Bypass Trusts
Generally speaking, unless there is a built-in exception, there is no step-up in basis for assets that are inherited through a bypass or credit-shelter trust, because such assets are outside the taxable gross estate of the surviving spouse. It is possible to build such treatment of step-up in basis into the bypass trust, however, if we are able to grant a general power of appointment to the surviving spouse.
Estate Taxes vs. Capital Gains
It’s important to note that step-up in basis can allow heirs to avoid capital gains taxes. However, it does not allow heirs to avoid estate taxes that apply to large inheritances.
In 2019, the estate tax is levied on property in excess of $11.4 million per individual ($22.8 million per married couple). In other words, if you and your spouse leave a $25 million estate to your heirs, $2.2 million of this amount will still be taxable even though your heirs’ cost basis in assets they inherited will be stepped up for capital gains tax purposes.
There are certainly ways to avoid estate taxes if you plan well, but step-up in basis doesn’t exclude the value of inherited property from a taxable estate all by itself.
Depreciation of Real Estate
Another huge advantage of the step-up rules is that a step-up in basis can give you a bigger depreciation tax benefit. If you aren’t familiar, the cost basis of residential real estate can be depreciated (deducted) over a period of 27.5 years. Obviously, a higher number divided by 27.5 years is a greater annual depreciation deduction than a smaller number would produce.
For example, let’s say that you inherit a property that your parents purchased 20 years ago for $100,000. It is now worth about $250,000. Not only does a $250,000 cost basis translate to a $9,091 annual depreciation deduction, but you can take this deduction every year throughout the full 27.5-year depreciation period even though the previous owner likely claimed depreciation deductions for the 20 years they owned it. What’s more, you won’t have to pay a penny of capital gains tax on the $150,000 increase in value that occurred while your parents owned it.
Step-Down in Basis
The term “step-up” in basis assumes that the asset will be worth more upon the death of the property owner than the property owner’s basis. While it is often the case that real property and investments increase in value over time, that is not necessarily the case. If the fair market value of an asset is worth less than the basis as of the date of the property owner’s death, then there will actually be a “step-down” in basis.
This can be detrimental.
For example, assume that you purchased a rental house at the height of the market for $1,000,000. However, the market declined and today it is worth $800,000. If you were to sell the house for $800,000, you would have a $200,000 loss. But assume that you held it until you died when it was worth $800,000. Your heir’s basis in the property would now be $800,000 (fair market value at date of death). If the heir sold it a year after your death when it appreciated in value to $900,000, your heir would have to pay capital gains tax on the $100,000 gain, despite the fact that your basis was $1,000,000!
So you have to be careful with these concepts.