Step Up in Basis

financial planning for retirement Mar 03, 2020

by Glenn Downing, MBA, CFP® 

 In a previous entry I discussed the difference in taxation of capital gains property vs. ordinary income property. That piece discussed what happens on your form 1040.  This piece looks ahead to your eventual mortality.  What happens when you die and bequeath these assets to your heirs?

A Step-Up in Basis Example

Previously I used the example of a stock that I bought at $100. Now say I leave it to my daughter at my death, and it is trading at $120 on the day I die. How is she taxed? Since stock is capital gains property, she gets a step up in basis to the date of death value. This means that she does not inherit my original basis of $100 – on the date of my death the stock is worth $120, so $120 becomes her new basis. That $20 gain is therefore never taxed! She could turn around and sell the stock the next day for $120 and have no taxable event. If she sold it two months later for $130/share,  she'd have a $10 long term capital gain. Remember, her basis is $120. How is the gain long term when she old held the shares for a month? The gain is always long term on inherited property.

What are Capital Assets?

What types of assets qualify for a step up in basis? Capital assets – those which are held for a period of time, are subject to market price fluctuations, and are sold at a profit or loss. Think of stocks, bonds, mutual funds, real estate (though not your personal residence), and business interests.

Another Step-Up Example

Here’s another example. Say your mother says to you, "Go ahead and put the Microsoft shares into your name, so they won’t have to go through probate when I die".  How generous!  But a bad tax move.  Turns out Mother & Dad bought 1000 shares of MSFT way back when for $100.00. As I write MSFT is trading at $224.97/share, so the position is worth $224,970.  That is a gain of $224,960.  If you transfer the title to yourself, she’s made a taxable gift to you (that’s another tax story for another day), and her basis of only $100.00 becomes your basis.  What would a smart son do? Say, "Oh no, Ma – it’s your stock. You keep it and feel comfortable. I can wait."  You WOULD ask her to re-title the account to Transfer on Death so there won’t be any probate. The result? You inherit; your basis is $224,970 or the date of death value - and there is no tax due if you turn around and sell the position! That’s $224,960 of gain that is never taxed! Using a capital gains rate of 15%, that is $33,744 that didn’t find its way to the IRS.

Ordinary Income Property

What assets do not qualify for the step up? Ordinary income property. This is interest received from the bank, annuity gains, and any money in a retirement account or IRA.

Annuities do not get a step up in basis, since they are ordinary income property, rather than capital gains property. Clearly there’s a big tradeoff with annuities: you gain income tax deferral of all gains while you’re alive, but your beneficiaries will pay taxes on the gains over your basis. Sort of a high class problem. I wouldn’t complain.

Retirement accounts also do not get a step up in basis. Remember – you made tax-deductible contributions to your IRA and 401K, so what comes out as distributions is ordinary income. It is also therefore ordinary income to your beneficiary, meaning when they cash in your IRA the gain is income-taxable.  Again, sort of a high class problem.  If, for example, a beneficiary received and distributed $100K from Dad’s IRA, he has an additional $100K in income that year, which pushes him up to a higher tax bracket.

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