You may have heard the phrase that when someone dies, they get a Step-Up in Basis for their assets. Let’s talk about what a Step-Up in Basis really is and the common mistakes that people make.
What is Basis?
When attorneys, accountants, and financial people are talking about basis, we are discussing “Cost Basis”. The overly simplistic way to think about cost basis is that it is the purchase price of an object. For example, if you purchase one share of stock for $40, then the initial basis of that stock is $40.
When a person sells property, that person has to pay a tax on the gain from the sale. Gain is determined by subtracting the sales price of the object from the basis of such object. For example, if I sold stock for $100 and the basis was $40, the gain would be $60. Accordingly, it is important to track the basis of the assets that you purchase so that you are paying tax only on the gain ($60), not the entire sales price ($100).
What can get confusing is that the basis of an object is not just the price a person has paid for it. If you pay money to improve the object (such as putting an addition on to a house), the basis will increase. If you depreciate an object for tax purposes, the basis will decrease. For a more thorough discussion about basis, see my post: Understanding Basis.
Additionally, an object’s basis can change as the result of death.
Basis of an Object Can Change Upon Death
Tracking basis has gotten easier with the advance of technology. Nevertheless, it is not always easy to know how much someone paid for an object, particularly an object that is a family heirloom. Let’s say your great-grandparent paid $50 for a vase, and gifted it to your mother, and you inherited it from her. Now you wish to sell it for $5,000.
If you cannot prove the basis, the government presumes that the basis is $0. Accordingly, you would need to pay tax on the full $5,000. No one thought that this was fair for people to track basis indefinitely. As a result, the government passed a law commonly referred to as the “Step-Up in Basis” rule.
Section 1014 of the Internal Revenue Code states that if a person holds property at the time of his or her death, it will receive a new basis equal to the fair market value of such property at the person’s date of death. This is known as the Step-up in Basis rule because, in most circumstances, the fair market value of the assets owned by a decedent is greater than the basis of those assets just before the decedent’s death. However, it truly is a resetting of the basis equal to the fair market value at the time of death. Therefore, if you buy an asset and it depreciates in value, there is actually a Step-Down in Basis at death.
Additionally, it would be a mistake to think that the Step-Up in Basis Rule applies in all situations.
Not All Assets Receive a Step-Up in Basis
Not all assets are eligible to receive a new basis when someone dies. For example, assets owned inside an IRA, 401(k), and other retirement accounts do not receive a step-up. Also, assets owned inside of an S-Corporation or C-Corporation usually do not receive a step-up in basis.
Furthermore, assets owned inside most irrevocable trusts do not receive a step-up in basis. (In fact, the IRS recently issued guidance on this confirming that unless the irrevocable trust assets are includible in the estate of the Grantor (or beneficiary), it does not receive a step up in basis. See: Revenue Rule 2023-2)
Assets inside of a partnership can receive a step-up, but certain timely tax elections must be filed.
How do you prove the new basis after death?
Depending upon the overall value of your estate at the time of your death, and the types of assets that you own, you may not need to do very much.
Real Estate
If you own real estate, we typically recommend obtaining an appraisal from a realtor. Some people prefer to rely on local township tax appraisals. If you need to file an estate tax return or an inheritance tax return, we would recommend getting an appraisal from an individual certified to do appraisals.
Publicly Traded Stocks and Funds
Publicly traded stocks and funds are also usually easy to track as their values can easily be found online. Moreover, if you ask your financial advisor to obtain this information for you, they typically will do so.*
*TIP: Never sell an asset after death until the investment institution updates the account with the Step-Up in Basis. Otherwise, you may pay extra taxes unnecessarily and reporting will be very difficult.
Private Companies
Private companies will require the services of a certified business appraiser.
Automobiles
In most instances, you can obtain the value of an automobile using a service such as Kelley Blue Book: https://www.kbb.com/whats-my-car-worth/
Filing a Form 706 Estate Tax Return
If your estate (including gifts prior to death) is over the federal estate tax exemption (currently $12.9M for 2023), your executor will need to file the Form 706 Estate Tax return.
In most situations, the official fair market value basis for assets that you own at the time of your death will be determined by the value listed on Form 706. However, Form 706 only needs to be filed if you have a taxable estate or if your estate wishes to claim portability.
Special Rule for Community Property
The attorneys at The Pollock Firm LLC are not licensed in any community property states. However, we would be remiss if we didn’t add that there is a special Step-Up in Basis rule when dealing with community property. Specifically, when married couples own community property and one spouse dies, you don’t just get a step-up for the part owned by the deceased spouse. You get a Step-Up in Basis for the entire community property. (See IRS Publication 555 in March of 2020.)
Can You Gift Property to a Relative and Receive it Back on Their Death with a Step-Up in Basis?
If the beneficiaries of a descendant’s property get to take appreciated property with a step up in basis, why don’t people just transfer their property to a sick relative and then have them bequeath it back them when the sick relative dies? Well, unfortunately, this rarely works.
First, under Section 1014(e), if you receive a property by gift, you have to hold it for one year before you (or your spouse) can get the benefit of the step-up in basis rule. However, this can still be a very viable strategy if you aren’t interested in receiving the asset back. For example, let’s say you gift highly appreciated stock to your mother. She can then leave it to your children with a step-up in basis when she dies.
You must be very careful when doing this strategy though. Possible dangers include:
- Your mom could sell the assets, causing a tax.
- Your mom could give the assets away or bequeath it to someone else.
- Perhaps your mom needs to go into a nursing facility, and these funds would be needed for her care before she qualifies for Medicaid.
- You won’t want to gift too much to Mom or it could adversely affect your estate tax exemption. (It could also adversely affect her exemption.)
- Depending upon where your mother lives, this could result in an inheritance tax when you receive the property back. (For example, Pennsylvania has an inheritance tax.)
Many of the dangers can be mitigated though by ensuring that you don’t give away too much and that you ensure the proper titling of assets.
Inheriting an Asset with a Step-Up in Basis is a Good Thing!
As long as there is no actual tax due on your death, it can often be a really good thing to receive an asset with a high Step-Up in Basis. This is particularly true for rental real estate.
As always, if you have any questions, we are here to help you with your probate, estate planning, and tax planning needs.
