Definition
“Step-Up in Basis” is a financial concept referring to the readjustment of the value of an appreciated asset for tax purposes upon inheritance. The stepped-up basis value is determined to be the market value of the asset at the time of the original owner’s death, not the value at the original purchase time. This reduces potential capital gains tax liability if the asset is later sold by the inheritor.
Key Takeaways
- “Step-Up in Basis” refers to the adjustment of the value of an appreciated asset for tax purposes upon inheritance. In this scenario, the asset’s base value is set to its higher, market value rather than the original cost of the asset.
- It’s an essential term in estate planning as it reduces the capital gains tax that would be owed by the inheritor when they decide to sell the asset. The tax is calculated based on the stepped-up basis (market value at the time of inheritance) rather than the cost basis (original purchase price).
- The “Step-Up in Basis” rule is only applied upon inheritance after death. It does not apply to gifts, where the receiver’s basis would simply be the same as the gifter’s cost basis.
Importance
The finance term “Step-Up in Basis” is important mainly during inheritance or transfer of assets.
It refers to the readjustment of the value of an appreciated asset for tax purposes upon inheritance, usually calculated as the market value of the asset at the time of the previous owner’s death, not the amount initially paid for the asset.
This readjusted value can potentially reduce the capital gains tax owed by the heir when they sell the asset because the inherited asset can increase in value over time.
Understanding how the “Step-Up in Basis” works can help individuals better plan their estate and tax strategies to minimize tax liabilities.
Explanation
The purpose of the step-up in basis lies fundamentally in mitigating the impact of taxes on appreciated assets, thereby providing tax advantages, particularly within the purview of estate planning. When an individual inherits an asset, the value of that asset might have significantly increased since the time it was first acquired by the original owner. If the inheritor were to sell this asset, the significant appreciation would result in substantial capital gains tax.
Here is where the step-up in basis comes into play. Its function is to readjust the value of the asset at the time of inheritance, the new value, known as the “stepped-up basis”, is then used to calculate capital gains tax, should the new owner decide to sell, potentially reducing the tax owed. Step-up in basis, therefore, serves as a crucial mechanism for protecting beneficiaries from hefty tax implications.
For example, if a parent purchased a home for $100,000 decades ago and that home is worth $500,000 when they pass away, the step-up in basis allows the child who inherits the home to avoid paying taxes on the $400,000 gain if they were to sell the home. The child’s basis would “step-up” to the fair market value at the time of inheritance, in this case, $500,000. This financial provision ensures that beneficiaries are not unduly penalised for intergenerational wealth transfers, particularly those that may have accrued substantial value over time.
Examples of Step-Up in Basis
1) Inheritance: If a person inherits a property that has appreciated in value, they receive a step-up in basis. Let’s say Bob’s father bought a house for $100,000 years ago and it’s now worth $500,
If he inherits the house after his father’s death, his basis in the property is stepped-up to the current market value ($500,000), instead of the original purchase value ($100,000). If Bob decides to sell the house immediately for $500,000, he will not owe any capital gains tax because the step-up in basis eliminates any gain.2) Stock Investments: Suppose Rachel’s mom purchased shares in a company for $10,000 and those shares are now worth $50,
If Rachel inherits those shares after her mom’s death, the cost basis for the shares will be stepped up to $50,000, the fair market value at the time of Rachel’s mom passing. If Rachel sells these shares at $50,000, she won’t owe any capital gains tax due to the step-up basis.3) Ownership Transfer: Another real-world example could be when a spouse dies and their share of the community property is passed to the surviving spouse. Let’s assume John and his wife, Alice, own a home together that was purchased for $200,
If the market value of the home is $600,000 at the time of Alice’s death, John will get a step-up in basis for both halves of the property. Thus, if he sells the property for $600,000, he will not owe any capital gains taxes because his adjusted cost basis would be $600,
Frequently Asked Questions: Step-Up in Basis
1. What is a Step-Up in Basis?
A Step-Up in Basis refers to the readjustment of the value of an appreciated asset for tax purposes upon inheritance, determined to be the fair market value of the asset at the time of the inheritor’s death.
2. How is a Step-Up in Basis calculated?
The Step-Up in Basis is calculated by subtracting the asset’s original cost from the fair market value at the time of the owner’s death.
3. What are the benefits of a Step-Up in Basis?
A Step-Up in Basis can drastically reduce the capital gains tax due upon the sale of inherited assets, as it minimizes the taxable gain by maximizing the cost basis of the asset.
4. Can a Step-Up in Basis apply to all assets?
Generally, most assets that appreciate in value and are then passed on to a beneficiary can receive a Step-Up in Basis, including stocks, bonds, real estate, and mutual funds.
5. Can a Step-Up in Basis also result in a Step-Down?
Yes, if the asset’s value has decreased at the decedent’s death, the basis is lowered to the date of death value. This is referred to as a “step-down”.
Related Entrepreneurship Terms
- Capital Gains Tax
- Inherited Assets
- Cost Basis
- Fair Market Value
- Estate Tax
Sources for More Information
- Investopedia: An extensive resource that provides beginner to advanced content on finance and investing terms.
- Internal Revenue Service (IRS): The U.S. government agency responsible for tax collection and tax law enforcement. It offers accurate information on taxes, including step-up in basis.
- Fidelity: An international brokerage which provides investment advice, discount brokerage services, retirement services, wealth management, securities execution and clearance, and other services.
- Charles Schwab: A bank and stock brokerage firm offering a variety of finance related services and educational materials.
