Step-Up In Basis – Inheritance
Step-up in basis is an important planning tool that can make taxable capital gains disappear when leaving property to your heirs. I want to talk about step-up in basis because it’s an important part as part of a retirement plan. For those that have taxable assets things like a non-retirement account stocks, bonds, mutual funds, and investment property, this can all be applied for a step-up in basis.
So, when you have an investment or an asset that grows in value, investors should be aware that if they sell it then they would owe capital gains taxes on the profit, or the difference between what they sold it for and what they bought it for. But when you are thinking of an inheritance to heirs, a step up in basis makes such an important and tax efficient transfer to your heirs.
What step up of basis is, is that it allows you to pass on non-retirement assets like an investment or an asset to an heir, and wipes away that capital gains impact to the heir.
For example, let’s say we have Jack and James, and Jack is a retiree and father to James. Jack purchased, let’s say, Apple stock at $20,000 10 years ago and now it’s worth $100,000 today. If he were to sell that, the stock, he would have a capital gains income that he would have to report on his taxes of about $80,000, which if we assume a capital gains rate of 15%, that would equal $12,000 in additional taxes that Jack would have to pay. If the goal is for Jack to donate, give that stock to his son, there’s a more tax efficient way to doing so, which is through the step-up in basis. If Jack simply allows that stock to pass on to James, James is able to inherit that stock at the $100,000 amount and completely avoid the capital gains responsibility.
Essentially, what happens is Jack’s cost basis of $20,000 that he originally purchased the stock for gets stepped up to the current value of the stock, which is worth $100,000. As soon as James owns that stock, at that point in time, any profit is then taxable to him. But, it’s a great way to pass down assets to future heirs in generations tax free so that they don’t have to deal with the capital gains impact.
One of the mistakes that we see retirees make is they want to give their assets or investments to their heirs prior to their passing, but with the correct knowledge of the step-up in basis, there is a lot more tax efficient way to pass on those assets to their heirs in future generations.
There’s one example that I had with a client that I was working with where it was siblings, two brothers. One brother had given an investment property to his other brother. And by doing so, when he passed away, the client that I was working with ultimately is now responsible for those capital gains. Because if you gift that property during one’s life, you get to essentially keep the same cost basis or what the original owner purchased it for.
So, it’s important to consider, especially later in retirement, if there’s any investment assets that you’re looking to pass on to future heirs to have a conversation about how the step-up in basis can apply.
Now there are a few takeaways and important rules to remember about this. Step up in basis can apply to stocks, bonds, mutual funds, real estate, and much more. Really, any type of asset that’s considered a capital asset, according to the IRS’ definitions, which it can be found IRS.gov.
The other important takeaway is that step up in basis works differently for spouses. Instead of being able to receive a full step-up in basis, a surviving spouse is only eligible to receive a step, a half step-up in basis if they own the property jointly, meaning if both husband and wife or both spouses own it together. If only one spouse owns it, then the other spouse could potentially get a full step-up in basis as well.
The other aspect of this is depending on where you live. There are certain states that are considered what’s called community property states such as California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington, where the step up in basis rules may be different.
So for anybody that wants to learn more about this, should consult with their financial advisor or tax advisor to specifically know how this may apply to their situation.
When it comes to your investment assets, it’s important that investors are aware of step-up in basis and have a plan on how those assets should be distributed to their heirs in the most tax efficient way.
Carson Johnson is a Certified Financial Planner™ professional at Peterson Wealth Advisors. Carson is also a National Social Security Advisor certificate holder, a Chartered Retirement Planning Counselor™, and holds a bachelor’s degree in Personal Financial Planning and a minor in Finance.