When a loved one passes away and their heirs inherit certain assets, they may receive a step-up in basis when transferred. When a person receives real estate, stocks, or other types of investment, the step-up in basis resets the asset’s fair market value to the date of the original owner’s death. Thanks to this tax rule, beneficiaries may reduce or even eliminate capital gains taxes that would otherwise be realized if the asset were sold.
A step-up in basis is an important aspect of estate planning, and it can help your heirs make informed financial decisions, but its impact depends on each taxpayer’s situation, the type of asset, and the applicable tax laws at the time of transfer. Below, Realized 1031 has shared a guide to help you further understand how the step-up basis works and all the things to consider.
To define a step-up in basis, we must first describe what the basis is. In the context of investing, the basis is the original purchase price of the asset. Knowing this value is important as it serves as the “basis” for taxation purposes. For example, an apartment complex with a basis of $400,000 will have that value as the starting point for calculating any capital gains or losses upon its eventual sale.
The step-up in basis for inherited assets simply means that the cost basis of the asset will be adjusted to the current fair market value at the previous owner’s death. The immediate advantage is that if an heir sells the inherited asset, they will only pay capital gains tax on any appreciation that occurs after they inherit it, not on the entire gain from when the deceased originally acquired it.
Let’s create an example to see how a stepped-up basis works. Let’s say you originally purchased an apartment complex for $400,000. After a few years, the value rose to $700,000, thanks to favorable market conditions. If you sold the asset before your death, you would need to pay capital gains taxes on the $300,000 appreciation. However, if you pass and your heirs receive the property, two scenarios can happen.
Step-up in basis benefits heirs by resetting the taxable value of the asset, often eliminating or significantly reducing capital gains taxes when the asset is later sold. A step-up in basis applies to many types of inherited assets, including real estate, stocks, bonds, and even collectibles. Here are key considerations to keep in mind during estate planning t.
What determines the FMV of the asset upon the original owner’s death? The same evaluation process applies to any other asset. We base the value on appraisals, market comparisons, or financial statements at the time of the original owner’s passing. The new valuation will become the adjusted cost basis.
If multiple heirs inherit a single asset, such as a house or stock portfolio, the step-up in basis is proportionally divided based on their ownership shares. This can impact how capital gains taxes are applied if some heirs choose to sell their share while others hold onto the asset. For example, the $700,000 apartment complex is halved between two heirs. If one of them sells their shares, their cost basis would now be $350,000.
The step-up in basis we’ve been discussing is based on the federal tax code. Some states will have their own inheritance rules, with some still imposing taxes on appreciated assets. As such, it’s important to consider your local laws during your estate planning to better safeguard your heirs from tax liability.
Not all types of assets qualify for step-up tax basis benefits. In general, assets that represent income in respect of a decedent (IRD) or that are tax-deferred do not qualify for a basis adjustment. For example, inheritance accounts, like Traditional IRAs, 401(k)s, and Roth IRAs, are not eligible. Instead, beneficiaries must pay income tax on withdrawals, following the original owner’s tax-deferred status. Roth IRAs have tax-free distributions, but their value is not adjusted for step-up in basis purposes.
Here are other types of assets that can’t have a step-up in basis.
There are two common categories of trusts: revocable and irrevocable trusts. The latter is a legal arrangement where the grantor — the person creating the trust — permanently transfers assets into the trust. The irrevocable trust is often used in estate planning and can help minimize estate taxes. Thanks to their structure, irrevocable trusts become separate entities from the grantor’s estate.
While these trusts become enforceable upon the death of the grantor (or any other outlined circumstance), they do not qualify as inherited property since they are no longer assets of the deceased grantor. This stipulation is made official under Revenue Ruling 2023-2. As such, it’s important to understand the distinctions between revocable and irrevocable trusts during estate planning.
Revocable trusts do typicaly qualify for a step-up in basis. However, they have certain disadvantages that may not suit your estate planning needs. For example, funds from a revocable trust can be taken to pay your estate’s taxes upon your death, diminishing what your heirs receive.
Another consideration for the step-up in basis practice is the one-year rule. if an individual gives an appreciated asset to someone who dies within one year of the gift, and the asset is then inherited back by the original donor, the step-up in basis is disallowed. This rule is designed to prevent taxpayers from avoiding capital gains by using short-term gifting and inheritance strategies.
This stipulation most commonly refers to spousal transfers to hold an asset for at least one year before they sell the property. Children and non-spousal heirs always receive a step-up in basis, regardless of when they sell the asset.
The community property designation applies to some states. In these jurisdictions, property acquired during the marriage is generally considered jointly owned by both spouses. When one spouse dies, the remaining spouse receives a full step-up in basis on the entire asset, not just the deceased spouse’s portion. Community property rules generally override the IRS’s one-year rule. This doesn’t mean that these states have higher authority than the IRS, however. This outcome reflects how ownership and basis rules interact under both state and federal law, rather than one “overriding” the other.
A 1031 exchange allows you to swap properties for others of similar value, avoiding constructive receipt and deferring capital gains taxes. In theory, you can keep exchanging like-kind assets indefinitely. Once you make a sale, the gains from all previous exchanges will be taxable. This can be a challenge, but thankfully, the step-up in basis does apply to 1031 exchange assets. Whatever the FMV of the property is upon the death of the investor will become the step-up cost basis for the heirs.
The step-up in basis is a valuable tax benefit for estate planning, letting your heirs reduce or eliminate capital gains from the assets they inherit after your death. This provision resets the value of your property upon your passing to its current FMV, eliminating any capital gains during your life. This benefit even applies to 1031 exchange properties, making the step-up in basis a crucial consideration for long-term real estate investment strategies.
The tax and estate planning information offered by the advisor is general in nature. It is provided for informational purposes only and should not be construed as legal or tax advice. Always consult an attorney or tax professional regarding your specific legal or tax situation.
Article written by: Story Amplify. Story Amplify is a marketing agency that offers services such as copywriting across industries, including financial services, real estate investment services, and miscellaneous small businesses.
Sources:
https://www.irs.gov/taxtopics/tc703
https://www.investopedia.com/terms/s/stepupinbasis.asp
https://www.investopedia.com/ask/answers/12/what-is-an-annuity.asp
https://www.thetaxadviser.com/issues/2023/nov/rev-rul-2023-2s-impact-on-estate-plans.html