What is a step-up in cost basis, and why does it matter for my estate plan?
Have you heard the term cost basis or step-up thrown around in the news lately? Are you wondering whether you should know what it is or why it matters to you? Step-ups in your cost basis are incredibly important in your estate planning. But why?
(As always, I am an attorney, but I am not YOUR attorney. Nothing in this post should be construed as legal or tax advice or to create an attorney-client relationship. The information here is purely for informational or educational purposes. You should always consult with a licensed attorney in your jurisdiction about your circumstances. )
What is cost basis?
The IRS, estate planners, investment advisors, and other professionals all use terms that make sense to them but would never be used in the real world.
Jargon like “cost basis” serve only to confuse the average client who is already nervous about meeting with the professional in the first place.
Let me assure you that terms like cost basis are far simpler than you might imagine.
Cast Basis Is What You Pay for Something
Cost basis basically just means what you paid for something. Did you buy a house for $100,000? Your cost basis is $100,000.
Did you purchase a piece of business machinery for $25,000? Your basis is $25,000 (before you depreciate it).
Similarly, do you have an investment account that you built up with $25,000 of earned income? Your cost basis is $25,000.
Why does your basis matter?
Your cost basis helps to establish your gain…you know…for tax purposes.
Knowing your basis in a particular property, asset, or account is important for figuring your taxes or your capital gains. Knowing what you paid for something helps us assess how much tax you need to pay if you sell it.
Take that house, for example. If you sell the house that you purchased for $100,000 later for $150,000 you probably have a taxable gain.
However, you don’t pay taxes on the entire $150,000. Instead, we subtract out the cost basis and pay tax only on the gain (capital gain!).
The appreciation or gain apply to investment accounts as well.
For example, if your investment account that you paid $25,000 into, grows to $100,000, then your gain is $75,000. If you cash out the account, then you pay tax on the gain, not the entire $100,000.
You paid taxes on the earned income when you placed it into the investment account. (Different rules might apply to your federally qualified retirement account.)
We all understand this simple concept, but what does it have to do with estate planning? Well, different rules for establishing cost basis apply to assets owned at death.
At death, your assets receive a step-up in cost basis.
What is a step-up at death?
Under current legislation, assets you own at death, with limited exception, take advantage of an artificial tax benefit. Currently, most assets that pass by reason of death have a step-up in cost basis.
Instead of calculating gain by taking what the asset is worth minus what you paid for it, we calculate the gain as what the asset is worth minus what the asset was worth at the owners’ death.
Examples of step-ups
Therefore, if grandpa paid $30,000 for a house in Southern California in 1969, but the house is worth $500,000 the day grandpa passes away, then the basis is $500.000.
If grandpa sold the house even moments before dying, he would have paid gains taxes on $470,000 in appreciation. But, by keeping the house and passing it at death, he saves his heirs capital gains taxes, estate income taxes, and potentially estate taxes.
Let’s look at another example:
In 1974, father purchases land for $200.00 per acre. Father farms the land for his entire life. Over the course of the decades, the land around the farm acreage becomes more and more developed. A shopping mall, an amphitheater, and several housing developments move in.
In 2021, father passes away and gifts the land to his three children. The three children decide to sell the land to a property developer at a whopping $50,000 per acre.
If father had sold the land to the developer during his lifetime, he would have paid gains on the property of roughly $48,800 per acre multiplied by his applicable capital gains rate.
However, by passing it at death, the children are able to sell the land and pay little to no capital gains.
And, with current capital gains rates for estates between 15% and 20%, this saves the children as much as $7,000 to $9,000 per acre in taxes. This is a substantial tax savings and can completely transform your heirs’ futures.
How does my basis factor into my estate plan?
With limited exception (IRAs and 401ks are subject to different rules), your estate planner will want to take advantage of your step-ups in cost basis.
Family property that has passed for generations, houses that are now in highly desirable neighborhoods, investment accounts that have reaped generous returns are all assets that your estate planning attorney will want to preserve to limit taxes.
This is where trusts, rental agreements, family partnerships, and more come in.
Take that farm property, for example. If dad wants to reap the benefits of the appreciated property without realizing all of the gains from a sale, then he might transfer the land into a revocable living trust.
Or, he might form a limited partnership, or other estate planning mechanism where he can continue to gain income but pass the asset at death.
Comparatively, if grandpa can no longer live in his house in southern California but doesn’t want to pay a whopping capital gains tax, he can keep the property until his death in a trust that rents the house.
That way, grandpa continues to receive the rental income, but the house has a step-up in basis upon his death. Grandpa continues to benefit from the property, but he saves his heirs a huge amount of taxes upon his death.
Beware Changing legislation
Beware that this step-up rule could change by legislation at any time.
Remember, a step-up in cost basis is an artificial structure. Legislation created the step-up, and legislation can take it away.
Even many proposals for the Build Back Better Plan in 2021 planned to repeal the step-up in cost basis.
As some legislators look to estates and wealth transfers as a mechanism to raise more tax revenue, the step-up is not guaranteed to stay.
Thus, you should always review your estate plan with your estate planning attorney regularly to ensure that your plans not only achieve your wishes but also take advantage of current tax laws.
RELATED POST: WHEN SHOULD I UPDATE MY ESTATE PLAN
Your estate planning attorney might encourage you to use your high basis assets first and preserve your low basis assets in various estate planning mechanisms.
Contrastingly, if the step-up in basis is ever repealed, then your estate planner might advise you to move your low basis assets into a trust, make gifts, or transfer into shares.
Using step-ups in your estate plan
Understanding how basis and the step-up in basis at death ultimately determines your tax liabilities at death is very important.
Don’t let tax and legal jargon scare you into believing that the step-up in cost basis is too complicated for you. Consult with an estate planning attorney to determine whether your low basis assets need special planning.
And, if your consultant throws out terms like basis, step-up, and cost basis, then hopefully you find that those concepts aren’t so difficult to understand here!
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