Understanding Step-Up in Cost Basis: What It Means for You

One of the most important tax benefits available to individuals passing down or inheriting assets is the step-up in cost basis. Yet, many people are unfamiliar with how it works and how it can save families significant money in taxes.

Whether you're planning your estate or standing to inherit assets, understanding this concept can help you make smarter financial decisions.

Here’s an easy-to-follow explanation of the step-up in cost basis, how it works, and why it matters.

What Is Cost Basis?

Before we dive into the step-up, let’s define cost basis. Cost basis is the original value of an asset for tax purposes. Typically, this is the purchase price plus any adjustments, like improvements or fees.

For example, if you bought stock for $10,000 and later sold it for $15,000, your cost basis is $10,000. The difference—$5,000—is your capital gain, which may be subject to taxes.

What Is a Step-Up in Cost Basis?

A step-up in cost basis occurs when an asset’s cost basis is “stepped up” to its market value at the time of the owner’s death. This means that any unrealized capital gains that occurred during the owner’s lifetime are effectively wiped out for the beneficiary.

Let’s say your parent bought a piece of property for $100,000 years ago. By the time of their passing, the property is worth $300,000. If you inherit it, the cost basis steps up to $300,000. If you sell the property for $310,000, your taxable gain is only $10,000 instead of $210,000.

This step-up applies to most inherited assets as of the date of the decedent’s death. Alternatively, the executor may use an alternate valuation date, which is six months after the date of death, if it reduces the estate tax owed.

Why Is This Important for Estate Planning?

For those looking to pass down assets, the step-up in cost basis can significantly reduce the tax burden for their heirs. It’s a powerful estate planning tool that helps preserve wealth across generations.

Without a step-up in basis, your heirs would be responsible for capital gains taxes on the difference between the original purchase price and the sale price of the asset. This could result in substantial taxes on appreciated assets like real estate or stocks.

Assets Eligible for Step-Up in Basis

Not all assets receive a step-up in cost basis. Here’s what typically qualifies:

• Stocks, Bonds and Mutual Funds: Any publicly traded investments.
• Real Estate: Including personal homes, rental properties, or vacant land.
• Personal Property: Items like art, jewelry, or collectibles.

Important Note: Retirement accounts like IRAs or 401(k)s are not eligible for a step-up in basis, as withdrawals from these accounts are taxed as income. For more about inherited retirement account withdrawals, check out this article.

Step-Up in Community Property States

If you live in a community property state, both halves of jointly owned property receive a step-up in basis when one spouse dies. In non-community property states, only the deceased spouse’s half of the property receives the step-up.

For example, if you and your spouse purchased a home for $300,000 and it’s worth $600,000 at your spouse’s death, in a community property state, the new basis for the entire property would be $600,000. In other states, the surviving spouse’s basis would only step up for their half, making it $450,000.

The Potential Impact on Heirs

The step-up in cost basis often makes inheriting assets far more tax-efficient than receiving them as gifts during the original owner’s lifetime. That’s because when you gift an asset, the recipient inherits your original cost basis.

For instance:

• If your parent gifts you stock worth $300,000 that they bought for $50,000, and you sell it later, you’re responsible for capital gains taxes on $250,000.
• If you inherit the same stock instead, your cost basis is $300,000, and no taxes are owed unless it grows further after you inherit it.

What’s the Catch?

While the step-up in cost basis is beneficial, there are potential considerations:

• Future Tax Law Changes: Proposals to eliminate or reduce the step-up benefit have surfaced in recent years. Staying informed is crucial.
• Estate Taxes: If the total value of the estate exceeds the federal or state exemption limits, estate taxes may still apply.

Therefore, understanding how it fits into your overall financial picture can be complex.

This is where working with a financial adviser can make a difference, as they can help you navigate these rules, identify potential risks and create a plan that benefits you and your heirs.

The Bottom Line

Whether you’re planning your estate or preparing to inherit, understanding how the step-up in cost basis works can help you minimize taxes and preserve wealth.

If you’re unsure how the step-up applies to your situation, working with a financial adviser can help. Advisers can guide you through strategies to optimize your estate plan or inheritance while navigating any tax implications. Schedule a free consultation to start creating your financial plan today.