Step-Up in Basis Rule-Common Mistakes
What is a Step-up in Basis?
In general, when you sell an asset that has appreciated in value, you pay taxes on the gain. For example, if you own stocks, the “capital gain” is generally calculated as the difference between your purchase price and sale price. How much tax you have to pay for the capital gain depends on your tax brackets (see this chart on 2021 Tax Brackets).
However, there is a special rule for inherited property known as the step-up in basis rule. Here’s how it works: David inherits a house from his uncle who bought the house in 1982 for $70,000. The home was worth $800,000 at the time of his uncle’s death. If David decides to sell the house, his basis will be $800,000 so he will only be taxed on the difference between what he sold it for and his new stepped-up basis of $800,000.
We publish a periodic newsletter on wealth management related topics. Click below to subscribe:
“Double” the Step-up in Basis
Those who reside in a community property state such as California can take advantage of the “Double Step-up in basis” rule with proper planning. Here’s an example of how the “double” step-up basis works: Henry and Alice bought a house in 1982 for $70,000. They created a revocable living trust and deeded the house to the trust. When Henry died in 2010, the house stayed in the survivor’s trust and Alice got the full step-up basis for the house which was the market value at Henry’s death of $800,000. When Alice passed away in 2013, the house was worth $850,000 which became the new basis for Alice’s son John who inherited it. In short, John inherited a house that essentially had stepped up in basis twice to $850,000! Consider the amount of taxes John would have had to pay if he had not been able to use the “Double Step-Up” rule!
Common Mistakes
To take advantage of the “step-up or double step-up in basis” rule, you need to avoid certain pitfalls:
Owning your home with your children: If you intend to avoid probate and for your children to own your real property when you pass, your children should inherit your property through a trust and NOT own it in common with you while you are alive. In our previous example, if instead of having their revocable living trust own the house, Henry and Alice owned their home in common with their son John, John will not be able to use the “step-up in basis” rule and will realize capital gains from the appreciation.
Holding title of home in joint tenancy with spouse: if one holds title as joint tenancy, his/her surviving spouse will retain their original cost basis and not get a full “double step-up in basis”. See this guide on How Should One Hold Appreciated Assets.
The step-up can also be a “step-down” if values have dropped at the time of death - so you need to be aware of the market values of your assets and any adjustments you plan to make to the ownership/title of those assets.
Summary
This step-up in basis rule is one of the biggest tax breaks in the Internal Revenue code to you or your loved ones if you have highly appreciated assets. How do you ensure you play by the rules and don’t forfeit the step-up rule benefits? First and foremost, you should discuss with your financial and estate advisors to check whether your property has community property in character and if you should change how you hold title to the property.
We are a fee only financial advisor in La Jolla, CA. If you'd like to meet and discuss your finances please click below to set up a time: