Last week, we discussed some of the basic rules, terms, and figures related to estate and gift tax. This week, we’ll tackle the ‘step-up’ in basis at death. You may hear some politicians and pundits call this a giant tax loophole that needs to be closed. I won’t get into the politics of whether this provision is a loophole or not, but will say it is a provision that impacts far more people than just the rich.
WHAT EXACTLY IS THE STEP UP IN BASIS AT DEATH?
- This rule says that when someone dies, most of their assets will receive a new tax basis and holding period. The new tax basis is the fair market value as of date of death, regardless of the original purchase price. This allows the decedent’s heirs to know what the income tax consequences will be post-death.
- Assume I bought some hunting land 10 years ago for $100,000 and it is worth $150,000 at my death. If I sell the land during life, I will owe tax on the $50,000 gain.
- If I own it at death, though, my heirs will take the land with a tax basis of $150,000. If they sell it the next day for $150,000, there will not be any income tax due on the sale.
YOU SAID THE STEP-UP APPLIES TO MOST ASSETS – WHAT DOESN’T IT APPLY TO?
- The primary type of asset that does not receive a basis change at death falls under a category that the IRS calls income in respect of a decedent (or IRD).
- The most common example of an IRD asset is someone’s IRA, 401(k) or other tax deferred account. There is no basis step-up at death for these. These accounts will still be subject to income tax when paid out after death to my heirs.
- Another common asset that does not receive a basis change is life insurance death benefits paid out after death.
ARE THERE OTHER EXCEPTIONS OR RULES TO BE AWARE OF?
- Certainly, but we will only discuss the basic rules that apply to most people here.
- First, be aware that this can also be a step-down in basis. Assume, I bought shares of Apple earlier in 2022 when it was at $170 per share. Today it is worth about $140 per share. If I die before selling the stock, that $30 loss simply vanishes altogether. With proper planning, the tax loss could have been preserved.
- Second, there are special rules and planning needed for spouses in marital or community property states. WI is a marital property state. This can present some unique opportunities with proper planning and also pitfalls without proper planning.
- Lastly, recall that we discussed gifting last week. Be aware that a gift during life gives up the step-up in basis that would otherwise be available at death.
Be sure to talk to a tax professional if you have any questions about the step-up in basis at death.