Understanding Step-Up in Basis
by Ann Webb
Have you ever wondered what “cost” (or “basis”) is for tax purposes when an individual inherits property or receives gifts from another? This is an important area and is too often overlooked when families start to put their affairs in order.
Under the fair market value basis rules (also known as the “step-up and step-down” rules), heirs receive a basis in inherited property equal to its date-of-death value. For example, if A bought X Corp. stock in 1935 for $500 and it's worth $5 million at A's death, the basis is stepped up to $5 million in the hands of A's heirs and all of that gain escapes income taxation forever.
The fair market value basis rules apply to inherited property that's includible in the deceased's gross estate, regardless if a federal estate tax return was filed. These rules also apply to property inherited from foreign persons, who aren't subject to U.S. estate tax.
The rules apply to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his or her inheritance. The fair market value basis rules also don't apply to reinvestments of estate assets by fiduciaries.
It's crucial to understand the fair market value basis rules so that you don't pay more tax than you're legally required to. Let’s look at some strategies and how they impact gain or loss on disposition of property.
Using the same facts from above, if A, instead of dying owning the stock, decided to make a gift of it in honor of A's 100th birthday, the “step-up” in basis (from $500 to $5 million) would be lost. Property that has gone up in value acquired by gift is subject to the “carryover” basis rules: the donee takes the same basis the donor had in it (just $500), plus a portion of any gift tax the donor pays on the gift.
A “step-down,” instead of a “step-up,” occurs if a decedent dies owning property that has declined in value. In that case the basis is lowered to the date-of-death value. Proper planning calls for seeking to avoid this loss of basis. In this case, however, giving the property away before death won't preserve the basis: when property which has gone down in value is the subject of a gift, the donee must take the date of gift value as his basis (for purposes of determining his loss on a later sale). The best idea for property which has declined in value, therefore, is for the owner to sell it before death so he can enjoy the tax benefits of the loss.
Although the above discussion refers to the date-of-death value, the value is different in some cases. Where the decedent's executor makes the alternate valuation election, the basis will be determined from the date six months after the date of death (or, if the property is distributed or otherwise disposed of by the estate within the six-month period, the date of distribution or other disposition).
Step-up in basis can be an effective, yet complicated, tax and estate planning tool. To consider your specific circumstances and opportunities, call us today.
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Ann Webb joined Larson Gross in 2010 and specializes in serving individuals with their U.S. tax planning and preparation needs.