Step up in basis at death

In short

A friend of mine once asked why his father never sold the old farm shares, even as the family fretted about taxes. If someone you love holds assets that have grown a great deal, the answer is often a rule about basis. Basis is the starting number used to measure a taxable gain, and it is usually what the owner paid. When the owner dies, the tax code resets that number to the market value on the date of death. The gain that built up during life is then wiped out for income tax purposes. It is not wiped out for estate tax purposes, and the two taxes are separate. Ask a tax lawyer about both before any big move.

The whole of it

What it is

I once watched an old rancher count what he had built by walking the fence line, and he never once talked about what each post cost him. Basis works the other way. It is the cost number on the books, and it matters because tax is charged on the gain above it. Section 1014 of the Internal Revenue Code sets the rule for property that passes because of a death. The heir's basis becomes the fair market value on the date of death. The executor may instead choose an alternate valuation date, but only if it lowers both the gross estate and the estate tax. That date is generally six months after death.

Think about a stock bought long ago for $40,000 that is worth $4,000,000 at death. The family of the owner would have owed tax on $3,960,000 of gain had the owner sold the day before. After death, the heir's basis is $4,000,000. A sale at that price creates no gain at all. The rule has been in the code for a very long time, and it applies to stock, land, a business, and art alike.

How it works

If you are holding an asset that has grown for decades, you have probably felt the pull between selling and keeping. The step up is a big reason the keeping can look attractive. The income tax on the gain simply does not get collected on assets held until death. The Internal Revenue Service explains the basis rule for inherited property in Publication 551, which covers basis of assets.

The rule also works in the other direction. If an asset lost value, the basis steps down to the lower market value. That is why families sometimes sell a losing asset before death and keep a winning one. I make no recommendation here. I only note how the arithmetic runs.

Two details trip people up. First, only property included in the decedent's gross estate gets the new basis. Second, the heir's holding period for an inherited asset is treated as long term, no matter how briefly the heir has owned it. So a quick sale after inheriting is taxed at the long term rate on any gain above the new basis.

The estate tax sits on top of all this. The federal estate tax applies to estates above the exclusion amount, which is the current figure, which the official source publishes each year. The top rate on the amount over the exclusion is the current figure, which the official source publishes each year. An estate below the exclusion owes no federal estate tax. For the very wealthy, though, the exclusion is small next to the estate. So the step up usually shows up together with an estate tax bill, and the estate tax is paid first. The heir gets a high basis, but the estate paid for it.

Trusts matter here too. Assets in a revocable trust are included in the estate, so they get the step up. Assets given away during life in a gift generally keep the giver's old basis, which is called carryover basis. That difference is the heart of many planning talks. A gift removes the asset from the estate but also gives up the reset. Some irrevocable trusts hold assets outside the estate, and those assets generally do not step up at all.

The numbers, and where to find yours

You will find the plain numbers in a few places. The estate tax exclusion and the top rate are set by law and change by year, and the Internal Revenue Service posts them on its estate tax page, so the site fills in the current figure, which the official source publishes each year and the current figure, which the official source publishes each year from there. The long term capital gains rate also comes from the law, and for a high earner it is the current figure, which the official source publishes each year. There is also a surtax on investment income for high earners, called the net investment income tax, and its rate is the current figure, which the official source publishes each year.

Your own basis lives in your records. Brokerage statements show cost basis for stock. For land or a business, you will want purchase papers and records of any improvements. If the records are gone, the heir will have a hard time proving the number. After a death, the executor generally gets an appraisal as of the date of death, and that appraisal becomes the new basis. Keep it. Estates that file a return must also report values to heirs on Form 8971 and Schedule A, which the Internal Revenue Service describes in its form instructions.

A worked example

A neighbor of mine named Harold Whitfield owned a block of shares in a family manufacturing company. He bought them for $2,000,000 in 1985. By the time he died, they were worth $60,000,000. His daughter Margaret inherited them.

Look first at what a sale before death would have meant. The gain would be $60,000,000 minus $2,000,000, which is $58,000,000. At the long term rate the current figure, which the official source publishes each year, plus the investment income surtax at the current figure, which the official source publishes each year, the bill would be large. Say the combined rate were 23.8 percent, as an illustration only. Then $58,000,000 times 0.238 is $13,804,000 of tax.

Now look at what happened. Harold held the shares until death. The step up reset the basis to $60,000,000. When Margaret sold for $60,000,000, her gain was $60,000,000 minus $60,000,000, which is $0. The income tax was $0.

The estate did not escape, though. The estate was larger than the exclusion, so the amount over the current figure, which the official source publishes each year was taxed at up to the current figure, which the official source publishes each year. Suppose the exclusion were $13,000,000 for illustration. Then $60,000,000 minus $13,000,000 is $47,000,000 taxed. At 40 percent, that is $18,800,000. So the family paid estate tax and no income tax. Both figures here are made up to show the steps, so use the real ones from the Internal Revenue Service.

Where it goes wrong

I have seen good families get hurt by a plan that looked clever on paper. The first mistake is to treat the step up as free. The estate tax can cost more than the income tax would have. Holding a large position only to get a reset can also mean carrying one big risk for years. A fall in price costs real money, and no rule refunds it.

The second mistake is gifting too soon. A person who gives away a highly appreciated asset passes along the old basis. The receiver may then owe tax on the whole gain. A friend of mine learned this when his mother gave him land worth far more than she paid, and he later sold it.

The third mistake is poor paperwork. Without a date of death appraisal, the basis is a fight with the tax agency. Joint property can also confuse people, since in many cases only the part owned by the decedent steps up. For a married couple in a community property state, both halves of community property can step up at the first death, and that is a state law point to confirm.

Finally, laws change. Proposals to limit the step up have been discussed in Congress over the years. None of them changes what the code says today, so check the current text of Section 1014 before relying on it.

Questions to answer before you leave this page

Do you know what you paid for your largest holdings, and can you prove it with records? Would a sale during life cost more in tax than the estate would owe if you held on? Have you asked a tax lawyer how the estate tax exclusion fits your whole picture, including trusts and gifts? Which assets sit inside your estate, and which sit outside where no reset applies? If someone you love inherits from you, will they know where the appraisal and the basis records are kept? And have you talked about all of this with the people it touches, while there is still time to listen?