What is Tax Basis?
Tax basis is the amount of a taxpayer’s investment in property for tax purposes. This basis is usually used in calculations for depreciation and amortization.
What is Step-Up in Basis?
The adjustment of the value of an appreciated asset for tax purposes upon inheritance, which applies to all inherited assets, including stocks, bonds, and real estate, is known as a step-up in basis. This adjustment in value alters the basis for the inherited property to the asset’s fair market value as of the date of death, rather than what the decedent initially paid for it.
Reducing Capital Gains with Step-Up in Basis
When an asset is left to a beneficiary by a decedent, the asset’s value is usually higher than when the original owner acquired it. This increase in value will typically increase the amount of capital gains. However, with a step-up in basis, any appreciation in the asset’s value occurring prior to the original owner’s death is excluded from taxation, thereby reducing the beneficiary’s capital gains tax liability. The benefits of step-up basis to a beneficiary include:
- No capital gains tax if the asset is immediately sold upon transfer.
- If the asset is held and sold later, the capital gains tax will be calculated based on the beneficiary’s new stepped-up basis.
- Assets kept by a beneficiary and passed to a new heir later benefit by taking another step-up in basis to fair market value.
Carryover Basis vs Step – Up in Basis
When an individual, before death, transfers an asset or gifts property to another, a carryover basis is used to determine the tax basis. In these situations, an adjustment to fair market value is not considered but rather the basis remains the same as the initial owner's original cost basis. The difference in capital gains tax between carryover basis and step-up basis can be considerable. Consider an asset originally acquired for $1 million that has appreciated to $3 million dollars and a 23.5% capital gains tax. If this asset is transferred or gifted before the owner’s death, the 23.8% capital gains tax applied on the appreciated value, will result in a capital gains tax of $476,000. However, if the same asset is transferred after the owner’s death with a step-up in basis, the resulting capital gains tax will be $0 because only the fair market value for the asset will be considered, not the appreciation in value.