Estate Taxes: What Is ‘Step Up In Basis’

When you’re grieving the loss of a loved one, your mind is understandably not focused on the tax implications of whatever assets you may have inherited. However, one of the tasks you eventually must attend to is the disposition of the property your loved one left behind. If you or other heirs have inherited property that has appreciated in value since the deceased person acquired it, the Step-Up Basis in capital gains tax could potentially save you a lot of money in taxes.

Everything you own is viewed as a potential asset by the IRS. Whenever you dispose of an asset – either through sale or gift, the transfer generates either a capital gain or a capital loss. If the property has increased in value since you obtained it, the result is a capital gain. If the value of the asset has decreased, the result is a capital loss.

You are taxed (or receive a tax credit) for the difference between the price when it was originally acquired and the value of the asset when the owner disposes of it. If the value of the property has increased since the original owner obtained it, and the disposition of the asset occurs because of the death of the original owner, then the IRS would assess capital gains taxes on the heir.

Without the Step-Up basis for calculating capital gains taxes on inherited assets, the IRS would potentially gain huge windfalls from assets that were held for years or decades and which had appreciated significantly in value. This situation would create a disincentive to save and invest, especially for taxpayers in their later years.

With the step-up basis in place, capital gains tax is not collected on the increased value that accumulated while the original owner was alive. Therefore, taxpayers have a significant incentive to retain property expected to appreciate in value until they die. By contrast, taxpayers would have an incentive to sell property that depreciates while they are still alive.

Your fictional Uncle Floyd was quite wealthy. He was also an active investor and particularly talented at picking stocks that consistently increase in value. He purchased one particular set of stocks at the bargain price of $2 per share.Upon his death, your Uncle Floyd’s stock was worth $1,500 per share, which represents a huge capital gain for you, his only heir.

Without the Step-Up Basis, you would be liable for capital gains tax on the accumulated value of the difference between $2 per share which your Uncle Floyd paid for the stock and the $1,500 per share that the stock is valued at now. But with the Step-Up Basis in place, the IRS ignores that accumulated value. You are not taxed on the value that the stock accumulated between the time Uncle Floyd purchased it and you inherited it. You would only pay capital gains tax on any increase in value over and above $1,500 once you sell or dispose of the stock. If the stock suddenly loses value and you dump the stock for less than $1,500 per share, you would pay no capital gains tax.

The Step-Up Basis was originally set to sunset in 2009. This meant that it would not apply to the estates of anyone who died after December 31, 2009. However, along with other revisions made in the estate tax code, this sunset provision was removed. While the sunset provision may be re-imposed at a later date, given the present disposition of Congress, such action seems unlikely in the short term.