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What is step up basis in simple terms?
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What Is Step Up Basis
The step up basis refers to a tax rule allowing a person to adjust the cost basis (or value) of an asset or property received by a beneficiary following a persons’ death.
In other words, the beneficiary or recipient of the property of an inherited asset will receive a “step up” to the asset purchase price to the fair market value of the asset at the moment it was transferred following the owner’s death.
Ultimately, when the beneficiary sells the same asset in the future, he or she will pay less in capital gains tax as a result of the step up tax adjustment.
When you purchase an asset like a stock, bond, real estate, or other, the cost basis of your asset will be equal to your initial purchase price.
For example, if you buy a real estate property for $300,000, your asset’s basis will be set to $300,000.
In many cases, the cost basis can get adjusted over time.
For example, if you invest an additional $100,000 making structural improvements to your real estate property, your initial cost basis of $300,000 will be adjusted to $400,000.
Similarly, if you depreciate your real estate property for tax purposes by a factor of $10,000 per year, after four years, your property’s adjusted cost basis will go down to $360,000.
When you sell an asset today at the fair market value, the difference between the amount you receive and the cost basis of your asset will be your capital gains or capital losses.
For example, if you bought stocks for $50,000 and sold them for $75,000, your capital gains will be $25,000.
In essence, you will need to pay taxes on your profit of $25,000.
Step Up Basis After Death
In some cases, families may hold an asset for generations.
To the extent the assets are never sold and passed down from one generation to another generation, the transfer of the asset to the beneficiaries will not be subject to capital gains taxes.
However, if the beneficiary chooses to sell the asset, then the capital gains tax will be calculated based on the asset’s step up in basis at death as opposed to the initial purchase price by the deceased.
For example, imagine a person bought a real estate property a long time ago for $20,000 and it’s worth $500,000 today.
If the person dies and passes on the property to his or her heirs, the property will have a set up in basis at death to $500,000.
Imagine the heirs sell the property in the future for $700,000, in that case, the capital gains will be $200,000 as it will be the difference between the sales price and the tax step up upon the original owner’s death.
How Setp Up Tax Rule Works
The general rule under the US tax code (Internal Revenue Code 1014) is that when a person (the beneficiary) receives an asset as inheritance following another person’s death (the benefactor), the beneficiary’s cost basis will be equal to the fair market value of the asset on the benefactor’s death.
This can lead to either a tax basis step up or a step down.
Let’s look at what they mean.
Step Up Basis
The step up basis IRS is when the cost basis of the asset or property is adjusted upwards.
For example, if a benefactor purchased a home for $25,000, the benefactor’s cost basis in that home would be of the same value.
If the benefactor dies and the home is worth $250,000, then the beneficiary’s step up basis will be equal to $250,000.
It’s as if the beneficiary purchased the property for $250,000 instead of getting a carryover basis of $25,000.
Step Down Basis
The step down basis is when an asset’s cost basis is adjusted downwards.
For example, if a person bought a very expensive car that was originally worth $200,000 and at the moment of his or her death, the car was only worth $120,000, the beneficiary will get a setp down in basis when inheriting the car.
It’s as if the beneficiary purchased the automobile at $120,000 (and not at the benefactor’s original purchase price).
Double Step Up Basis
In some cases, the beneficiary of a property may take advantage of a double step up basis on an inherited property.
For example, John and Mary purchase a home for $200,000 in the 1970s.
They form a revocable living trust and purchase their home through the trust.
In the early 2000s, John dies and so the property gets a step up tax basis to $400,000.
Ten years later, Mary dies and the property gets another step up in basis at death of spouse to $600,000.
If Helen, John and Mary’s daughter, inherits the property, she will benefit from a double step up in basis as her cost basis will be set to $600,000.
With a double tax basis step up, Helen’s tax liability will be lower should she sell the property one day and realize the capital gains.
Step Up Basis Pros And Cons
What are the advantages and disadvantages of having a step up basis tax rule?
The main advantage is for the beneficiary of a property due to an inheritance.
In essence, a step up basis for the surviving spouse or beneficiary is adjusted to reflect the value of the property at death.
As a result, the beneficiary will be able to use the higher market value of the property as his or her cost basis in the property to calculate tax liability in the future.
Wealthy families and those who are able to leave assets to their beneficiaries will be able to avoid paying taxes on property that is transferred from a deceased to the heirs.
Ultimately, the beneficiaries will have a lot less capital gains taxes to pay when the property basis is stepped up as opposed to carried over.
Many consider that the step up basis loophole benefits the rich and wealthy as they are able to “escape” paying capital gains taxes every time the property cost basis is stepped up.
In many cases, wealth individuals will form a trust to hold investments and assets allowing the beneficiaries have a lower exposure to capital gains tax.
The critics suggest that the step up tax rule should be replaced by a rule where some capital gains tax is charged on property that is transferred from a benefactor to the beneficiary on the former’s death.
Step Up Basis Example
Let’s look at an example of the step up in tax basis to better illustrate the concept.
It’s important to properly calculate a property’s cost basis so that you can determine how much you will need to pay in capital gains or if you can recognize a capital loss.
The cost basis step up is a rule allowing a person receiving an asset following another person’s death to increase or adjust upwards the deceased person’s cost basis in the inherited property.
For example, imagine that Mary’s father purchased a real estate property 75 years ago at $30,000 (her father’s cost basis would have been set to $30,000).
Mary’s father passes away and at the moment of his death, the property was worth $500,000.
Following her father’s death, Mary is the sole beneficiary of her father’s estate and so she inherits her father’s real estate property.
For tax purposes, Mary will get a inheritance step up basis to be equal to the value of the property on her father’s death ($500,000).
If Mary sells the property in the future, she will pay capital gains on the difference between the price she sells the property for and her stepped up cost basis.
If she sells the property below $500,000, she will then report a capital loss.
Step Up In Basis Takeaways
So, there you have it!
What is a step up in basis in simple terms?
In essence, under the US tax code, a person receiving an asset from a person following that person’s death will receive the asset with a basis step up to the market value of the property at the moment the initial owner passed away.
In other words, the tax basis step up will generally be higher than the original owner’s cost basis and will represent the beneficiary’s “purchase price” for tax purposes.
For example, if a person bought an asset for $50,000 long time ago worth $300,000 at the moment of his or her death, the beneficiary’s cost basis (or the IRS steup up in basis) will be $300,000 and not $50,000 originally paid by the deceased.
The advantage in having a higher cost basis to the beneficiary is that when the asset is sold, the amount of capital gains taxes to be paid will be lower.
For example, let’s use our previous example, if the beneficiary sells the asset for $500,000, he or she will pay capital gains taxes on $200,000 instead of $450,000.
Fundamentally, the step up basis rule is used to calculate a beneficiary’s tax liability on an inherited asset.
I hope I was able to explain to you what is step up in basis, how the step up in basis at death works, and why it’s important.
Remember, this article is intended to give you general information.
If you need tax advice or are dealing with a tax issue, be sure to consult a tax attorney or tax professional for qualified advice.
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What Does Step Up Basis Mean
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