Step-Up in Tax Basis or Step-Down?

Stocks trending down

Will the proposed tax legislation currently before Congress eliminate the step-up in tax cost basis? What exactly do I mean when I refer to a step-up?

Step-Up with Stocks 

If I buy a stock for $1/share and it is now $51 share, if I sell that stock, I realize a $50/share capital gain. Under our Internal Revenue Code (IRC), I’m taxed on that gain, which is the difference between the sales price and my tax cost basis – the amount that it cost me to purchase the shares.

If I don’t sell those shares before my death, and then those shares are bequeathed to my daughter, she receives a “step-up” equal to the fair market value of those shares at the time of my death. Assume that the value is $51/share. My daughter then sells the shares for $52. She only realizes a $1 capital gain, so her capital gains tax is much lower than what I would have realized had I sold the shares at my death.

Step-Up with Assets

What about depreciable assets, such as a commercial building? Suppose I paid $100,000 for a building and added a structure that cost me $300,000. My tax cost basis is $400,000. Over the years I depreciated that building. During that time, I was able to expense $250,000 of depreciation, charging it against my income, which lowered the amount of income tax I would pay. My tax cost basis is now $150,000.

If I sell the building for $500,000 my realized capital gain is $350,000, which represents the difference between the sales price of $500,000 and my depreciated tax cost basis of $150,000. What if I die before I sell the building, and my daughter inherits it? She gets a step-up in tax cost basis equal to its current fair market value ($500,000) and gets to depreciate it all over again!

This step-up in tax cost basis is valuable to anyone who inherits assets whose value is more than the decedent owner’s basis. If a new law were to strike down this feature, it would result in higher capital gains taxes for nearly everyone who inherits stocks, mutual funds, homes, and buildings. I should note that certain assets don’t receive a basis step-up, including annuities and tax-deferred retirement accounts, such as IRA and 401k accounts.

“What about Step-Down?”

It’s important to understand that that the law doesn’t just adjust tax basis upward, despite its common name, “step-up.” The law could result in a step-down because the applicable IRC Section 1014 states, “…the basis of property passed from a decedent shall, if not sold, exchanged, or otherwise disposed of before the decedent’s death by such person, be – the fair market value of the property at the date of decedent’s death.”

If, for example, I purchased shares of a company at $100/share, and at the time of my death the value is only $25/share, my daughter inherits those shares with a tax cost basis equal to the fair market value at the time of my death. If she later sells them at $25/share, she recognizes no capital loss. Had I sold the shares before my death, I would have realized a $75 capital loss that I could have used to offset capital gains that I realized.

Keep Track of Your Documents!

What if I don’t know what my tax cost basis in an asset is? Suppose that I sell shares of stock at $100/share but can’t find documentation as to what my basis is. The IRS assumes that my basis is zero! Consequently, if I sell the shares, I realize a capital gain equal to the entire sales price! This rule could pose significant problems for anyone inheriting property, should the adjustment to fair market value under IRC §1014 be eliminated. If my daughter can’t find records justifying my basis, any asset of mine that she sells would result in a realization of the entire sales price as capital gain, even if it would have been a loss to me!

How often might beneficiaries not be able to document the basis of inherited assets? I believe more frequently than not, resulting in a potential windfall to the IRS.

It Affects More Than Just Millionaires 

Talk about a blow to the middle class. The elimination of this law doesn’t just affect the wealthy. It affects anyone who inherits assets. It certainly benefits those inheriting millions more than those inheriting a few thousand dollars, but the effect on the less wealthy recipients seems to hit harder. They need the money more, yet they still pay capital gains taxes when liquidating inherited property.

Here’s the good news – at least hopeful news: In my 31+ years practicing estate planning law, Congress has from time to time considered eliminating the step-up. It hasn’t happened. Maybe it won’t happen now.

We can only wait and see.

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