Estate Planning: How Does the Basis Step-Up Rule Work?

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Understanding how the basis step-up rule operates is important for navigating the complexities of estate planning and taxation, as it can significantly impact the financial outcomes of inheritances.

The basis step-up rule effectively wipes out any built-in capital gain when someone inherits an asset from a decedent. Because the amount of capital gain determines the amount of capital gains tax owed, basis step-up is considered one of the most powerful and important tools in the estate and tax planning universe.

Basis step-up simplified

Say an individual owns shares in a company with a fair market value (FMV) of $100,000. They acquired the stock many years ago for the purchase price of just $10,000, which is their acquisition cost and the cost “basis.” If the shares are sold for the FMV of $100,000, they would owe capital gain tax on the $90,000 difference between the sale price and their basis.

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However, what if they don’t sell the stock during their lifetime, but instead leave it to their child as an inheritance? Under the Internal Revenue Code (IRC), the child will inherit the stock with a new, “stepped-up” basis equal to the $100,000 FMV of the stock as of the date of the parent’s death. If the child then sells the stock for its FMV of $100,000, no capital gain tax is owed on the sale because the difference between the sale price of $100,000 and the $100,000 stepped-up basis is $0.*

When basis step-up applies

With very few exceptions, an asset will get a basis step-up if it’s subject to estate tax. Basis step-up can be thought of as the lollipop after the estate tax shot. The opposite is also true. If an asset was not subject to estate tax, then it will not receive a basis step-up.

The estate inclusion requirement doesn’t mean that estate tax must be paid in order for a basis step-up to apply; the asset simply has to be subject to estate tax (i.e., included in the decedent’s gross estate). Even if an estate is under the estate tax lifetime exemption amount and therefore owes zero in estate tax, the estate’s assets will still receive a basis step-up because the assets were part of the estate tax calculation.

Determining fair market value

The IRC says that the new basis of an inherited asset is its “fair market value” at the date of the decedent’s death. However, it doesn’t provide specific guidance as to how that value should be determined. Fortunately, Treasury regulations and the IRS provide guidance for determining the FMV of some common asset classes, notably marketable securities.

Cash, of course, doesn’t need to be valued since it’s always worth its face amount. Other common assets with a relatively low value (such as household effects, vehicles, clothing, etc.) may generally be valued using a good faith estimate. Artwork, collectibles, antiques and other difficult-to-value or high-value assets may require a specialized appraisal. Real estate values must generally be substantiated by a qualified appraisal, which means that a formal appraisal by a licensed real estate appraiser should be obtained in most cases.

Closely held businesses and nontraded securities will always require a formal valuation from a CPA or other qualified specialist.

Full basis step-up for community property

Community property is a form of ownership available to married couples in certain states. States that recognize community property ownership are generally called community property states, while states that don’t recognize this form of ownership are generally called common law states.** A unique basis step-up rule applies to married couples who own community property. It provides that any asset held as community property will receive a 100% basis step-up at the first spouse’s death, even though half of the community property isn’t owned by the deceased spouse.

For married couples in common law states, ownership of assets acquired during marriage can be kept separate or owned jointly. When one spouse passes away, only the assets included in the deceased spouse’s estate will get a basis step-up. That would be 100% of the deceased spouse’s separate property, but only 50% of jointly owned property since each spouse is deemed to own half of any joint assets.

For married couples who own community property, not only does the deceased spouse’s share of the community property get a full basis step-up under the general rule of IRC Section 1014(a), but the surviving spouse’s share also gets a full basis step-up under the special rule.

No two situations are the same and the question of whether an asset will benefit from a basis step-up should always be viewed in the context of long-term estate planning.

* One common exception to this general rule is that income in respect of a decedent (IRD) does not get a step-up at the decedent’s death. This is why IRAs do not get a basis step-up at the account owner’s death, because the income attributable to the IRA constitutes IRD.

** The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington. Wisconsin is also generally considered a community property state, although it uses the term “marital property,” which is functionally identical to community property for estate inclusion and basis step-up purposes.

The information provided is not intended to serve as specific financial, legal, or tax advice. Some of the content provided comes from third parties that are not affiliated with Mercer Advisors. The information is believed to be accurate but is not guaranteed or warranted by Mercer Advisors. Mercer Global Advisors Inc. is registered with the Securities and Exchange Commission and delivers all investment-related services. Mercer Advisors Inc. is a parent company of Mercer Global Advisors Inc. and is not involved with investment services.

Disclaimer

This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

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Logan Baker is Vice President of Estate Planning with Mercer Advisors Family Wealth Services Group in Denver. In this role, Logan helps Mercer Advisors clients with estate, tax and wealth transfer planning. Originally from the Orlando area, Logan received his undergraduate degree in Legal Studies from the University of Central Florida and his MBA from Florida State University. Logan attended law school and received his J.D. at the University of Montana. After law school, he studied tax law and estate planning and received his LL.M. in Taxation from the New York University School of Law.