Step Up in Basis

It was time for Yaakov Averich to clean up some affairs so they could be dealt with smoothly after 120. He’d looked it up, and estate tax wouldn’t be an issue for his kids. Though there was a small portfolio of rental homes he’d owned for years, the dollar amount was beneath the “death tax” exemption. Yaakov figured he’d sell these houses and give the money to his kids now, while he was alive, and be done with it. His accountant was not in favor of this plan, though. 

Why is selling investments often a bad financial move for one’s estate?

Powerful Tax Savings After 120

The step-up in basis is a very powerful and unique tax freebie, but unfortunately, it’s only available upon death. Basically, upon death, all accrued investment capital gains, which normally would be taxed upon a sale, are wiped out. The step-up happens on its own after 120 as long as someone doesn’t mess it up by gifting assets in advance, wasting a potential fortune in straightforward tax breaks. Step-up is a crucial tax strategy to maximize wealth preservation across generations, and it’s a shame to blow it due to poor planning.

Basis Basics

To understand the power of basis step-up, let’s go back to basic tax principles. Taxes are generally imposed only after an income or profit is locked in, not when it’s theoretical. So, investors pay tax on ongoing investment income like interest, rent, and dividends as it comes in but not on the “paper” gains of the investment, no matter how high the valuation soars. Taxes on gains in value are owed when the growth is locked in via a sale, and kicking the tax can down the road for as long as possible leaves more money for investment growth.

Sale Basis + Taxable Gains

How are taxable gains calculated upon the sale of an investment? The IRS looks at the sale price and subtracts the investment “basis,” meaning what it cost to buy the investment, and then taxes the profit. (The basis of the property can go up if a property needed interim capital improvements, if tax was paid on distributions, or it can go down through depreciation.) Accountants and savvy investors are always very interested in the basis of a property, and many investment strategies are based on lowering basis to defer gains, and then minimize taxes when a property is finally sold.

Selling Now is Taxable

Imagine Yaakov owns five investment houses which he bought many years ago for $1 million, and they’re worth $5 million today. If he sells them now, he’ll pay tax on the $4 million in capital gains ($5 million sale price – $1 million in basis = $4 million in taxable gains). He’d have about $4 million to give out after taxes, which is nice but it could be nicer if Uncle Sam wouldn’t take a hefty chunk of the gains.

Shev V’al Ta’aseh Adif

On the other hand, if Yaakov simply leaves things as they are until after 120 and his kids sell the houses for the same $5 million, zero tax is owed! The tax laws says that upon death, the basis of a property is stepped up to the value as of the date of death. Since the basis of the inherited property is $5 million, not a nickel is owed upon a sale at that price ($5 million sale  – $5 million stepped-up basis = zero gains). Just like that, the kids have an extra million for themselves.

Get Help if Necessary

By gifting the portfolio in life, Yaakov is unnecessarily costing his kids a $4 million deduction or about $ 1 million in cash. He should keep the houses, and after 120, the kids can keep them or sell them. Either way, the basis is stepped up and a tax cloud is cleared up. If Yaakov is not up to managing his properties anymore, perhaps he can ask one of his kids to take over management, maybe paying him a few dollars for the service. Or maybe he needs to hire a property management company. Either way, the kids would definitely prefer to work something out than to waste a $4 million tax deduction.

Step-up Beats Gifting

Astute readers may wonder if perhaps Yaakov should gift the actual houses to his children in life, allowing them to take over his basis as is the law for gifted assets. But that’s still far inferior to step-up in basis. If they get the houses as gifts instead of inheritance, they can hold the assets and do 1031 exchanges, kicking the can down the road for themselves. But that’s not nearly as good as step-up in basis, which actually wipes out taxable gains. With a step-up in basis, they can avoid 1031 questions entirely.

Swap Till You Drop

In fact, step-up in basis is the ideal strategy for a property portfolio that has a very low basis due to a lifetime of depreciation, cost segregation, and 1031 exchanges. Kids can keep the assets they inherit if they want to, but the basis is reset to a new, fresh high. If they do want to diversify or even exit real estate, they can sell with zero gains tax. Savvy real estate investors can “swap till they drop,” which is an unbelievably sweet tax deal.

Common Step-up Scenarios

Step-up commonly pops up with inherited stocks and mutual funds too. Often, the tax bite upon selling inherited securities is very low since the basis is stepped up upon death. Also, a widow or widower may be able to sell half or even all of the couple’s investment assets with zero gains tax. Depending on who technically owned the assets, there is a step-up upon death which wipes out the gains. Even if they sell the property down the line, the basis will probably be much higher and taxes lower.

Good Tax Advice Pays for Itself

The laws governing spousal treatment of assets can get pretty technical, though. The laws differ depending on how the accounts were titled as well as the intricacies of state laws. Also, wealth management and estate-planning strategies involving trusts can be in conflict with the step-up in basis freebies. Assets held in irrevocable trusts don’t qualify for step–up, so deciding the ideal balance between estate-planning strategies is quite complicated. Paying for good estate planning advice is usually a great investment. Messing up here can be quite costly.

Want to dig deeper?

Try these related articles

Donating Appreciated Investments: A Powerful Tax Saving Strategy

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Understanding The Need for Wills

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