By Gary K. Liska, MS, CFP®, AIF, CRPC, AAMS
Founding Partner, CFO
Understanding the rules regarding a step-up in cost basis
What is ‘cost basis’ and why does it matter when planning your estate? The cost basis of any asset is simply the original price you purchased it for. If you purchased 1000 shares of a stock for $25 which are now worth $50/share, the value of your investment is $50,000, but its cost basis is $25,000.
When the original owner of an asset dies, however, there’s a special provision which allows for certain inherited assets to receive a ‘step-up’ in basis. This means that rather than the price originally paid for the asset, the cost basis of the asset is readjusted to its fair market value at the time it’s inherited.
How does a step-up in basis help?
Thanks to the step-up provision, when a beneficiary sells an asset they inherit, rather than having to pay capital gains tax on all the appreciation since the asset was purchased, they need only pay tax on whatever (if any) appreciation has occurred since they inherited it.
Let’s say you have an older relative who bought 1,000 shares of Tesla stock at $40/share in 2015. The relative dies in early December 2020 and you inherit the stock which had soared in value to $740/share. You then subsequently sell the stock for $780/share in early 2021. If there wasn’t a step-up in basis, you would have to pay capital gains taxes on $740,000 ($780,000 sale price – $40,000 purchase price). But because the value of the asset was stepped-up to $740/share when you inherited it, capital gains would only be due on the excess value ($40,000) gained since you inherited the stock.
On the other hand, when you gift assets while you’re still alive, the recipient takes over the original cost basis of the asset—so they would be responsible for ALL the accumulated capital gains when they sell it. As a means of tax-efficiently transferring highly appreciated assets to the next generation, it’s hard to beat the built-in benefits that a step-up in basis affords.
Deciding what to gift
While inheritance is generally the preferred strategy for highly appreciated stocks, real estate and/or a family business, most wealthy individuals don’t want their heirs to have to wait years and years before being able to benefit from and enjoy the family’s wealth.
Along with lesser appreciated stocks, bonds and funds, you may want to consider tax-deferred assets such as IRAs, 401(k) plan accounts and annuities as a source for gifting. Because these types of accounts have enjoyed the benefit of tax-deferred growth over the years, they’re not eligible for a step-up in basis if and when they are inherited.
What about trust assets?
Because revocable trusts are considered part of your estate, the assets held in the trust are generally eligible for a step-up in basis. Irrevocable trusts, on the other hand, are considered to exist outside your estate and therefore don’t typically benefit from step-up provisions.
But there are a few irrevocable trusts that enjoy a step-up in cost basis. One common example is a Marital Trust, which actually provides you with an opportunity for two separate step-ups—one upon the death of the first spouse, and another when the second spouse dies.
Other things you’ll want to factor into your decisions on whether to gift assets now or allow your heirs to inherit them include the current and projected future income tax bracket of your beneficiaries; the specifics of your estate plan; and any anticipated future changes to current tax law (e.g., the Biden tax plan published last fall called for an elimination of the step-up provision).
Most importantly, while a step-up in basis can be a powerful planning tool, any decisions regarding the gifting or inheriting of assets could have a significant long-term impact on your estate plan. Therefore, you should collaborate very closely with both your financial advisor and your attorney before making any decisions.
Gary K. Liska may be reached at 310 712-2323 or www.seia.com
Securities offered through Royal Alliance Associates, Inc. member FINRA/SIPC. Investment advisory services offered through SEIA, LLC, 2121 Avenue of the Stars, Suite 1600, Los Angeles, CA 90067, (310) 712-2323. Royal Alliance Associates, Inc. is separately owned and other entities and/or marketing names, products or services referenced here are independent of Royal Alliance Associates, Inc.