Estate Planning 101: What You Need to Know About the Step-Up in Cost Basis

If you are inheriting property such as a stock portfolio or real estate, you may benefit immensely from the step-up in cost basis rule.

Some even call it a tax loophole, but it was made possible by Section 1014(a) of the Internal Revenue Code.

So let’s talk a little about capital gains.

Suppose a loved one purchased $10,000 in stocks. That grows to $50,000. Had this person sold the assets, they would trigger capital gains of $40,000. This is the difference between the new appreciated value and the purchase value. So they’d face capital gains taxes. These depend on the length of time you held onto the asset and your income level.

If you sold a stock in one year or less, you’d face the less favorable short-term capital gains tax rates. These can be as high as 37 percent, depending on income. But if you sold the assets after a year or longer, you’d be taxed at the long-term rates of zero percent, 15 percent, or 20 percent.

But the highest earners may also be subject to the 3.8 percent net investment income tax.

But back to the previous example. The inheritor gets the appreciated stock portfolio with a new cost-basis of $50,000. But they don’t need to worry about capital gains taxes at the time of the transfer.

However, it’s not just stocks that can benefit from the step-up in cost basis. Some other examples of property that could undergo the step-up in basis include real estate, mutual funds, collectibles, fine art, and some business interests.

Say a loved one purchased a home for $50,000 in the 1970s. Fifty years later, the property grows to $500,000 in value. This person decides to leave behind the home to her son via her will. The cost-basis is now the appreciated fair market value of $500,000.

The son then decides to sell the home for $550,000 five years later. The capital gain is now only $50,000.

Without this tax rule, the son would have had a cost-basis of $50,000. This is the value the home was at when the mother originally purchased it. So after selling the home, the son could have been looking at a capital gain of $500,000.

Community property states are Arizona, California, Idaho, Louisiana, New Mexico, Nevada, Texas, Washington, and Wisconsin.

So, in these states, the surviving spouse gets a total step-up in basis on both ownership portions of all jointly owned assets.