Maximizing inheritance with a step up

The adjustment in basis is a crucial tax consideration – what can it mean for you?

A sometimes-overlooked component of estate planning, the adjustment in cost basis, can be a taxation game-changer. Under this tax provision, an inherited asset’s cost basis is determined not from the owner’s original purchase price, but from its value when inherited after death. Since most assets appreciate over time, this adjustment in basis is often called a “step up” in basis. A step-up can mean significant savings in taxes when an asset is sold. It’s a powerful way for beneficiaries to maximize their inheritance.

Generally, assets included in the decedent's gross estate will receive an adjustment in basis. For example, stocks, land, and business interests are all eligible for an adjustment in basis. However, some Income In Respect of the Decedent (IRD) assets, such as IRAs, 401(k)s, and annuities, aren’t eligible.

How step-up works

Under current tax law, the cost basis is the asset’s value on the date of the original owner’s death. Depending upon how long your heir holds the asset before selling and other factors affecting its valuation, the asset may technically accrue little to no gain – and your heir would face little to no capital gains tax on it.

Taxes being taxes, things can never be quite that simple. Some assets may decrease in value over time, leading to the application of a step-down basis. Furthermore, jointly owned assets between spouses may have different rules for basis adjustments when one of the spouses passes away. These different rules depend on the couple’s state of residence and whether it’s a community property or common law state.

What’s the scenario?

The first step in determining where the step-up basis may be helpful is to nail down your estate planning goals. Are you philanthropic? Do you want to leave your vacation home to your daughter, and your stocks to your grandchildren? Do you have an estate plan but think it might need review through the lens of the step-up basis?

Let’s take one common scenario to illustrate how the step-up can benefit your heirs: Ten years ago, you bought 20,000 shares of a company’s stock for $20 a share, so the original cost basis is the $400,000. Now those shares are worth $40 each, or $800,000, and you’d like your adult children to receive that stock.

Depending on your intent, you have several options to pass along that asset to your children. You could sell the shares, assume the tax liability, and gift your children cash. You could also directly transfer the shares, and they'd receive the same basis in your stock ($20 per share). Or you could name your children as beneficiaries of those shares. As long as those shares are in a taxable account and included in your gross estate when you pass away, they’ll get an adjustment in basis based on the fair market value on your date of death. If the fair market value of the shares is $50 per share at your passing, your children will receive a step up in basis to $50. The gain of $30 per share, or $600,000 gain will pass to your children free of any tax liability!

The step-up tax basis can be an important tool in estate and tax planning. Consult with tax professionals, your estate planning team and your financial advisor to find out which assets are eligible for an adjustment in basis and to identify the appropriate beneficiaries for each asset based on of your estate planning goals.

Raymond James does not provide tax advice. Please discuss these matters with your tax professional.

Sources: investopedia.com; smartasset.com; jdsupra.com; thinkadvisor.com; kitces.com