Why "Step-Up" in Basis is a Good Thing
"Basis" is an important income tax concept used to determine the amount of taxable income, or capital gain, that results when you transfer an asset. The basis of a particular asset is key in considering whether to transfer that property during your lifetime or at your death. Here I will briefly explain the basics of basis and how it may affect your decision.
Income tax “basis” is the amount a person invested in a specific asset. Your basis is equal to the amount that asset cost to acquire. By way of illustration, if you purchased a home for $300,000, your basis would be $300,000. If that home is later worth $500,000, your basis is still $300,000. “Gain” on the other hand refers to the amount you receive after sale of that asset, less the amount it cost to acquire that asset (or basis amount). If you later sell the house for $500,000, your gain on that asset would be $200,000.
Normally, when you give an asset to someone, the person receiving the asset keeps the same basis as the person who gave the asset. This is referred to as “carryover” basis. Any gain on the asset is calculated using the gift giver’s basis. If you give a gift of property to your sister, your sister would use the carryover basis amount to calculate gain. For example: if you originally paid $300,000 for your home and give it to your sister during your lifetime, her basis would be $300,000 regardless of the fair market value at the time of transfer. If she later sells the property for $500,000, her gain would be $200,000 using the basis of $300,000.
STEPPED UP BASIS
Notwithstanding any complicating factors, the basis of inherited property is equal to the property’s fair market value which is established on the date of death (or an alternate valuation date up to six months after the death). This is often referred to as “stepped up” basis. So rather than the basis remaining at the decedent’s investment amount, the person receiving the decedent’s property gets a “step-up” to fair market value on the date of death (or six months after). The step up creates an income tax advantage because the beneficiary will not have to pay income taxes on realized gain. Using the example above, if at the date your death the home is worth $500,000 and your sister sells it right away for $500,000 then no capital gains would be due. If she later sells it for $600,000, her gain would be $100,000 because her basis would be fair market value on the date your death. (Alternately, property may get a “step down” in basis if the fair market value of the property is less than the investment amount.)
You can see that getting a step up in basis is good for the person receiving the asset. If you inherit a house worth $500,000 at the time of the donor’s death then your basis in that asset is $500,000 and you can immediately sell that house with no income tax consequences!
Basis is an important factor in determining how married couples should hold title to their home. Depending on the form of ownership, you may or may not be able to take advantage of a step-up in basis should you outlive your spouse. Many married couples have their home titled as joint tenants. This can create a problem when one spouse dies and the survivor later sells the property because only the decedent’s portion of the property gets the step-up. The basis adjustment is limited to the decedent’s one-half interest. When property held by spouses as community property on the other hand, the survivor receives a step-up in basis at the death of the first spouse potentially creating significant income tax savings for the survivor if the property is later sold.
There may be other factors for not titling your home as community property but an issue that should be considered carefully and discussed with an estate planning attorney or tax professional.
*This discussion is intended to provide you with general information about income tax basis and does not include all of the variables in determining how your estate plan should be prepared. This handout is not intended to provide legal advice or legal opinions relating to your specific facts or circumstances. Before making and changes to your estate plan you should consult with your estate planning attorney and tax advisor to determine the best options for you and your family.