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How does the step-up basis work?

On Behalf of | Apr 25, 2021 | Estate Planning

There are several goals when creating an estate plan. One is to provide for your old age, but the other is to transfer assets to your family in the most efficient way possible. The step-up basis relates to the transfer of assets from one generation to the next.

When transferring your assets, you want as much of what you have to reach the hands of your heirs — not the government. However, poor planning could reduce the amount your heirs receive for two main reasons. Firstly, if you die owing debts, creditors could claim those assets. Secondly, the Internal Revenue Service (IRS) will try to take as much as the law allows.

The step-up basis is, right now, a way to reduce capital gains tax when you pass assets on

What is capital gains tax?

You must pay capital gains tax when you sell an asset for a profit. It can apply to anything from stocks to property, although there are exceptions. Your main home is a typical exclusion.

Imagine, for example, you invested $100,000 in stocks some years ago. They are now worth $500,000. What is the best way to pass them to your child?

You could sell them and pass the money to your child. Doing so means you will need to pay capital gains tax on the $400,000 in profit that you made. The rate of capital gains depends on your income for the year and how long you have held the investment.

Let’s say you need to pay capital gains tax at the rate of 20% on your $400,000 profit. That makes $80,000 in tax, leaving $420,000 for your child. However, if you pass the stocks to your child when you die, you can pass on the entire $500,000 thanks to the step-up basis.

How does the step-up basis reduce capital gains tax?

When you die, you leave the $500,000 in stocks to your child. A few years later, they sell them for $600,000. Does that mean they will need to pay capital gains tax on the entire $600,000 because they got them for free? Or that they need to pay it on the difference between the $600,000 sale price and the original $100,000 the stocks cost you? 

Neither. The step-up basis means the IRS considers the stocks’ cost as their value when you died and they passed to your child. So, if your child inherited them at $500,000 and sells them for $600,000, they would pay capital gains tax on the $100,000 gain.

Some consider the step-up basis a tax loophole that needs to be closed

The government has spent a lot of money over the last year and plans to spend much more. They will need to increase the tax they collect to fund that spending. Doing away with the step-up basis is one option politicians have mentioned. If they do, it could affect more people than other proposed changes.

Reducing the federal estate tax threshold from $11.7 million to $5 or $6 million is irrelevant to most people. Yet, most will inherit something. The worth of what they inherit will be reduced if they need to pay capital gains based on the original cost of the asset to their parents. That is what would happen if the government does away with the step-up basis.

If you are unsure how proposed changes will affect your estate plan, it’s wise to seek advice. You may need to alter your estate plans to ensure that you can pass as much of your assets as possible to your heirs. An attorney can help you understand more about your options for tax abatement when it comes to your estate.