How Does Step-Up in Basis Work?

by | Dec 27, 2022

Taxes are unavoidable in today’s economy for the most part. This includes all types of financial endeavors and areas of personal finance. Estate planning is no exception to this which means it is a good idea to have a tax strategy in mind when planning how to administer your estate after you pass away. 

One tool for mitigating capital gains tax liabilities is through the step-up in basis rules. 

What does “step-up in basis” mean? 

A step-up in basis refers to an increase in the cost basis of an asset for purposes of calculating capital gains tax liability. Cost basis is the starting valuation of an asset in determining how much the asset has appreciated in value for capital gains tax purposes when an asset is sold. The initial cost basis of an asset is the original price that the initial owner paid it. 

When there is a step-up in basis the cost basis for calculating capital gains tax liability is increased. The law allows this under certain circumstances when a beneficiary receives an inheritance from somebody who has passed away. 

Minimizing tax liability 

The objective of taking advantage of a step-up in basis is to help your intended heirs minimize how much capital gains tax they will have to pay if and when they eventually sell the assets that you have left to them through your estate plan. When your heir inherits your asset the market valuation of the asset at the time of inheriting the asset will be the new cost basis. 

Step-up in basis example 

To illustrate how step-up in basis works here is an example. Assume that you had purchased a share of a stock for $5 and at the time it passes to your beneficiary, the stock share is worth $10. Your beneficiary will have a step-up in basis which means the cost basis for the asset is $10. 

Now, when your beneficiary decides to sell the stock share which had appreciated to a value of $20, your heir will only be responsible for paying on $10 in appreciated value when it comes to calculating capital gains tax liability. 

Capital gains tax in estate planning 

As you can see, the law does provide opportunities for you to help your beneficiaries reduce capital gains tax liabilities through estate planning. However, each situation is different, and this can be particularly true when it comes to certain states which have different laws regulating step-up in basis. Married couples may have a different situation than single people when it comes to step-up in basis. Be sure to consult with a professional who has the knowledge to provide you with the strategic insight on dealing with capital gains during the estate planning process.