How Can a Step Up in Basis Help Your Estate Plan

step up in basisTaxes are one of the most confusing areas of the law. Whether this is intentional or not is subject to much debate, but one thing is certain – if you are able to play the game correctly, you can save yourself (and your heirs) lots of money.

Many people get confused by terms like “step up in basis,” when in reality it shouldn’t be that confusing. But then again, that is easy for me to say, I get paid to give legal advice including, from time to time, basic advice about taxes.

What is a Capital Gain?

Before we talk about what a step up in basis is, you need to understand the capital gains tax. Because when you receive a step up in basis, you are avoiding paying capital gains taxes.

A capital gains tax is the tax you pay when you sell an asset. This asset could be stocks, bonds, real estate, options, or any other security or asset. The tax is calculated by subtracting the amount you paid for the asset (i.e. your basis) from the amount you sold the asset for and multiplying your “gain” by the capital gains rate.

The capital gains rate will vary depending on how long you held the asset.

If you held the asset less than a year, you will pay a short-term capital gains rate and if you held it longer than a year, you would pay a long-term capital gains rate.

The rates will vary over time, but generally speaking, short-term rates are higher than long-term capital gains tax rates. This gives people an incentive to hold assets for longer than one year.

What is a Step Up in Basis?

A step up in basis is exactly what it sounds like, it’s an increase in the basis (i.e. the amount you paid) of an asset that happens when someone dies and transfers that asset to an heir.

What is effectively happening is that you are increasing the basis in the property and decreasing the capital gain for the person who inherits the property from you.

Can you see how powerful this is?

Maybe an example will help.

Let’s say you purchased $10,000 worth of Apple stock way back in the 90’s when it was trading around $1. (I’m not kidding, look it up, it was trading at 62 cents on May 9, 1997 – twenty years ago today).

Your $10,000 would have bought you 16,129 shares (split adjusted). Yesterday Apple closed at $153.01, making your original investment worth approximately $2.5 million today. If you decided to sell those shares today, you would incur a 15% capital gains tax rate on that sale, or $375,000.

Quite a tax hit, huh?

Here’s where the step up in basis comes into play.

Let’s say you passed away and gave those shares to your children. Their basis would “step up” to today’s share price of $153.01. Now, your children could sell those shares and wouldn’t have to pay any taxes at all.

Click here for more information on the interplay between estate taxes and capital gains taxes.

Final Thoughts

Not all assets qualify for a step up in basis. Retirement accounts such as IRA’s and 401(k)’s do not receive a step-up in basis, nor do bypass trusts.

But other assets, such as low-basis stock held in an individual account, your family home that was purchased thirty years ago, or even the family business that was started with a small loan and is now worth millions could all qualify for a step up in basis.

As you can see, effectively using a step up in basis is a tremendous estate planning tool.

Have more questions about a step up in basis?

Contact Cary estate planning attorney James Hart at 919-460-5422 to set up a planning session to learn how you can use a step up in basis to preserve your family’s wealth. Alternatively, you can fill out our contact form by clicking here.