Benefits of the Cost Basis Step Up
Clients planning to make gifts to family members or others often ask us whether it would be better to gift cash or investible assets. While the answer depends on the client’s specific situation, the ability to step up the cost basis of appreciated assets at death is an important consideration.
Why is Cost Basis Important?
Cost basis represents the original cost of a taxable asset, subject to adjustments such as depreciation. The cost basis is used to determine capital gains or losses when you sell the asset, and a higher cost basis is advantageous for tax purposes. For example, if you bought a share of stock for $15 and sold it for $17, the cost basis would be $15 and you would have created a $2 capital gain. If the same stock had a cost basis of $5, there would have been a $10 capital gain when it was sold for $15.
What is the Step Up?
Under the step up rule, inheritors of appreciated assets, such as investments and real estate, get to “step up” the cost basis to the date-of-death fair market value of the asset rather than the decedent’s original cost basis.
For example, let’s say Mary bought shares of stock for $10,000 in 1990 and the value of the shares at her death is $100,000. The cost basis for Mary’s daughter, who inherits the shares, would be $100,000. This is a significant tax advantage; if Mary had sold the shares before she died she would have had to pay capital gains tax on the $90,000 gain, but if Mary’s daughter sells the shares immediately after Mary’s death she will owe little or no capital gains tax. If Mary had wanted to gift to her daughter during Mary’s lifetime, she probably would have been better off using cash or assets with less appreciation.
The step-up rules apply to most assets inside of a decedent’s estate but tax-deferred retirement accounts are an exception. For tax-deferred accounts, such as IRAs and 401(k)s, there are separate taxation rules for inheritors, some of which recently changed as part of the SECURE Act.
How does the step-up work for spouses?
For separately owned assets, the step-up works the same as it would for other inheritors. For example, if Jane died this year owning a brokerage account in her name only, her husband Joe would receive a full step-up on the investments in the account.
For jointly owned assets, the amount of the step up will depend on the couple’s state of residence. For those living in “community property” states (currently Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the surviving spouse would generally receive a full step up in cost basis. For those living in all other states, the spouse would receive a step up worth one-half of the difference between the fair market value at death and the original cost basis. When the second spouse dies, inheritors would receive a step up to the fair market value at the second spouse’s death.
How We Can Help
Here at The Family Firm, our advisors regularly work with clients to construct gifting plans that meet their goals while maximizing tax efficiency. We’ll review your cash holdings, investments and real estate portfolio to determine what works best for personal and charitable giving now and in the future.