Taxes are oftentimes an area of concern for people when creating an estate plan. No need to fear, however, because for once there is good news regarding taxes. If you inherit certain assets, such as a house, you will receive a step-up in cost basis, which could save you a great deal in taxes. Knowing how to properly handle an asset during your life can allow you or your heirs to inherit an asset under favorable tax conditions.

A knowledgeable estate planning attorney should be able to advise you on the best ways to distribute your estate. By planning accordingly, you can be certain that your heirs will enjoy the benefit of receiving a step-up in cost basis. Mistakenly distributing your estate at the wrong time can cost your heirs thousands of dollars in taxes. Contact an estate planning attorney to make sure you avoid these pitfalls.

What Is Tax Basis?

Cost basis is the value of an asset at the time you purchase it.  Your cost basis, or just basis, will then be subtracted from the price you sell that asset for.  This difference is your taxable gain. Up to $250,000 of your gain, or $500,000 if you file taxes jointly with your spouse, can be tax-exempt for primary residences.  Any surplus over those thresholds can be taxed as capital gains.  

In order to meet the requirements for exemption, you must use the primary residence for at least two total years in the five-year period leading up to the sale of the home.  There are a few other eligibility requirements that you must pass, but they are too complex to delve into here and best addressed with an estate planning attorney.  You can qualify for a partial exemption if you only satisfy some of the eligibility requirements.  It is worth noting that you can also include the cost of home improvements to the $250,000 or $500,000 to help boost your exemption.

For example, let’s say you file taxes jointly with a spouse. If you buy a house for $200,000, your basis is $200,000.  If you then sell that house 25 years later for $900,000, you have a taxable gain of $700,000 ($900,000 – Basis & Exemption threshold).  The $200,000 difference ($700,000 minus the $500,000 allowed when filing jointly) will be taxed as a capital gain, assuming you hold the asset for at least a year.  Depending on your income, the gain will be taxed at a 0%, 15%, or 20% rate.  

If you have a household income of $150,000 per year, you would fall in the 15% bracket.  This means that a $100,000 profit you made on your house would be taxed at 15%, leaving you with an $85,000 gain.  

How Does Basis Apply to Inheritance?

This is where the good news comes in.  Per the U.S. Tax Code, the heirs of certain types of property will receive a stepped-up basis when they inherit the asset.  A stepped-up basis is a tax concept where the heirs inherit the property and assume a basis based on the current market value, not the value the decedent paid for the asset.

For example, your Uncle Jim bought a house for $50,000 in 1990.  He has lived in that house since he purchased it.  He recently passed away and left you as the sole heir.  The house is now worth $600,000.  You inherit the $600,000 basis, not the $50,000 basis Uncle Jim had.  If you immediately sell the house for $600,000, you will have no taxable gain.  Remember, the taxable gain is the value you sell the asset for minus your basis.  In this example that would be $600,000 – $600,000.  This results in no taxable gain for you.

If Uncle Jim had sold the house for $600,000 the year before he died, he would have had a taxable gain of $300,000 since his basis was $50,000 and he has a tax exemption of $250,000 ($600,000 – $50,000 = $550,000 – $250,000 exemption = $300,000).  Even though the property came into your family for $50,000, the U.S. tax code allows heirs to adopt a stepped-up basis for inherited properties.  

This can save you a good amount of money because if you had Uncle Jim’s basis, then you would have had a $550,000 taxable gain ($600,000 – $50,000).  A gain of that amount would see a 20% tax rate, leaving you with $440,000 profit instead of the entire $600,000.  Fortunately, the federal tax code allows heirs to receive a stepped-up basis.  In this example, the step-up in basis would have saved you $160,000 on taxes. 

Being aware of which assets receive a step-up in basis is important for estate planning because it may make more sense for you to hold an asset for the rest of your life rather than gifting it to an heir now.  If you gift an asset to an heir during your lifetime, the heir will incur your basis in the asset.  Using the Uncle Jim example, if Uncle Jim gifted you the house during his lifetime rather than leaving it to you in a will, you would adopt his $50,000 basis.  That would result in a $550,000 taxable gain on a $600,000 sale.  A qualified estate planning attorney can help you sort through your assets and instruct you on how to handle them in order to obtain the most favorable tax treatment for your heirs.

What Assets Get a Step-Up in Basis?

Based on the examples I have provided, you may be wondering whether real estate is the only asset that receives a stepped-up basis.  The answer is no.  Homes are not the only assets that receive a step-up in basis.  Other assets that receive this favorable treatment under IRC 1014 are:

• Stocks held in taxable accounts;
• Bonds held in taxable accounts;
• Mutual funds held in taxable accounts; and 
• Land

These other assets follow the same process as the house examples we discussed earlier.  Say your grandfather bought shares of a stock at $5 per share.  Your grandfather states in his will that you will inherit those shares upon his death.  When he passes, the shares are worth $15 each.  Your basis is $15 per share.  Perhaps you hang onto the shares for ten years and sell them for $25 per share.  Your taxable gain would be $10 per share ($25 – $15).  It is worth noting that retirement accounts and IRAs do not receive a stepped-up basis. 

How Does This Affect Estate Planning?

Being aware of the step-up in basis concept is an important part of properly caring for your estate.  The reason for this is that the stepped-up basis only applies once the asset has been inherited.  If you or a loved one would like their heirs to receive the asset on a stepped-up basis, then it must be inherited after passing.

For example, let’s say you bought a house for $200,000.  It is now worth $500,000.  If you gift the house to your children in your lifetime, they will adopt your $200,000 basis and be taxed on the $300,000 gain.  If you leave the house to them in a will or trust, they would adopt the stepped-up basis of $500,000, creating the favorable tax outcome we have been discussing.

By being mindful of the concept of steps-up in basis, you can help to maximize the tax favorability of your assets.  To understand how this would work with respect to your estate, we recommend contacting an estate planning attorney.

How an Attorney Can Help

A knowledgeable estate planning attorney should be able to counsel you as to which assets will and will not be subject to a step-up basis.  By properly planning which assets do and do not receive this treatment, you can develop a better understanding of how to handle certain assets during your lifetime.  At Rosenblum Law, our experienced estate planning team would be happy to assist you in making an estate plan that makes sense for both yourself and your loved ones.  For a free, no-obligation consultation, call 888-235-9021 to get your planning underway.