Stepping Up Your Understanding In Step-Up In Basis

By: Randall A. Denha, J.D., LL.M.

Remember “step up in basis” is a rule that can apply to capital gains on inherited assets. But essentially the tax basis of an asset is how we calculate capital gains. Ordinarily, if we have an asset like a house, our capital gains would be calculated by subtracting the purchase price of an asset from the sale price. The difference is the capital gain, which would then potentially be subject to tax.

If we were to inherit, for example, a home that had been owned by our parents for 30 years and apply this rule, then the capital gain would be the price that we sell it for today, minus the purchase price from 30 years ago. Because the purchase price from 30 years ago would likely be much less than we are selling it for today, the difference would likely result in a large capital gain. More gain equals more potential tax.

However, the tax code sets forth the step up in basis rule. Using our hypothetical example above, this rule changes how we calculate the capital gain. Rather than using the purchase price on our parents’ home from 30 years ago, we would use the value of the property on the date our surviving parent died. Typically, this means that the capital gain would be much, much lower. Therefore, less potential tax.

Thanks to a generous federal gift and estate tax exemption amount ($13.61 million for 2024), only the wealthiest of families are exposed to estate tax liability. For many, this means that estate planning now has a stronger focus on income tax planning. And one of the most valuable tax planning areas is the “stepped-up basis” rules.

What Assets Receive a Step-Up in Basis upon a Person’s Death?

The step-up in basis can apply to many kinds of assets, including (but not limited to):

• real estate
• personal property
• brokerage accounts
• stocks
• bonds
• bank accounts
• businesses
• art
• antiques
• collectibles

The stepped-up basis does not apply to the following types of assets:

• IRAs
• employer-sponsored retirement plans
• 401(k)s
• pensions
• tax-deferred annuities
• gifts made before death

Capital gains rules

Normally, when assets such as securities are sold, any resulting gain is a taxable capital gain. If the assets have been owned for longer than one year, the gain is taxed at favorable rates. The maximum tax rate on a long-term capital gain is 15% but increases to 20% for certain high-income individuals.

Conversely, a short-term capital gain is taxed at ordinary income tax rates, as high as 37%. Gains and losses are accounted for when filing a tax return, so high-taxed gains may be offset wholly or partially by losses.

The amount of a taxable gain is equal to the difference between the basis of the asset and the sale price. For example, if you acquire stock for $10,000 and then sell it for $50,000, your taxable capital gain is $40,000.

These basic rules apply to capital assets owned by an individual and sold during his or her lifetime. But a different set of rules apply to inherited assets.

Stepped-up basis rules

When assets are passed to the younger generation through inheritance, there are no income tax implications until the assets are sold. For these purposes, the basis for calculating gain is “stepped up” to the value of the assets on the date of death. Thus, only the appreciation in value since the individual inherited the assets is subject to tax. The appreciation during the deceased’s lifetime goes untaxed.

To illustrate the benefits, let’s look at a simplified example. Alan bought Steel Corp. stock 10 years ago for $1,000,000. In his will, he leaves all the Steel Corp. stock to his daughter, Barbara. When Alan dies, the stock is worth $2,500,000. Barbara’s basis is stepped up to $2,500,000.

When Barbara sells the stock two years later, it’s worth $2,700,000. Thus, she must pay a maximum 20% rate on her long-term capital gain. On these facts, Barbara has a $200,000 gain. With the 20% capital gains rate, she owes $40,000. Without the stepped-up basis, her tax on the $1,700,000 gain would be $340,000.

What happens if an asset declines in value after the deceased acquired it? The adjusted basis of the individual who inherits the assets is still the value on the date of death. This could result in a taxable gain on a subsequent sale if the value rebounds after death or a loss if the value continues to decline.

What about using a grantor trust?

An intentionally defective grantor trust (IDGT) is a powerful estate planning tool that allows the grantor to transfer assets into a trust while retaining certain powers or interests, which render the trust “defective” for income tax purposes but not for estate tax purposes. In other words, the assets transferred to the IDGT are removed from the taxpayer’s estate for federal gift and estate tax purposes, but not for income tax purposes. This defectiveness allows the grantor to personally report and pay the trust’s income taxes, further reducing the grantor’s taxable estate in the process. In addition, an IDGT serves as a vehicle to transfer appreciating assets, thereby removing all future appreciation from the date of the gift from the grantor’s taxable estate.

Generally, under IRC Section 1014(a), the basis of property in the hands of a person acquiring it from a decedent or to whom the property passed from the decedent, if the property is not sold, exchanged, or otherwise disposed of by that person before the decedent’s death, is the fair market value of the property as of the date of the decedent’s death. This method of determining basis is referred to as a step-up basis, and IRC Section 1014(b) lists the circumstances under which a step-up basis under IRC Section 1014(a) applies.

In Revenue Ruling 2023-02, the IRS held that the basis step-up under IRC Section 1014 does not apply to assets gifted to an irrevocable grantor trust because the assets are not included in the gross estate of the grantor for federal estate tax purposes. The ruling explains that in such cases the assets of the grantor trust are not considered as acquired or passed from a decedent by bequest, devise, inheritance, or otherwise within the meaning of Section 1014(b), and therefore, IRC Section 1014(a) does not apply. The ruling further states that for a basis step-up to apply, the property must be acquired or passed from a decedent. Revenue Ruling 2023-2 provides clarity on the treatment of IDGTs as it relates to a step-up in basis. This ruling affirms the continued effectiveness of such estate planning strategies, allowing grantors to retain limited control over the trust assets while reducing their taxable estate. However, unless the grantor is proactive, this comes at the cost of not receiving a stepped-up basis in such assets upon the passing of the grantor.

For estate and gift tax purposes, however, the trust is treated as an entity separate from the grantor. Generally, assets transferred to the trust are treated as completed gifts and, therefore, are not included in the grantor’s estate upon death.

The good news is that the language of Revenue Ruling 2023-2 makes it clear that it applies to trusts where the creator of the trust does “not retain a power to revoke or amend.” As a result, a well-prepared revocable trust that falls within the requirements of IRC Sec. 1014 should still enjoy the ability to transfer assets with a step-up in basis.

Making Gifts Have Value

One way to reduce estate tax liability is to make lifetime gifts to family members. Under the annual gift tax exclusion, you can give each recipient gifts valued up to $18,000 in 2024 without any gift tax ($36,000 per recipient for joint gifts by a married couple).

Property received from a donor of a lifetime gift takes a carryover basis. “Carryover basis” means that the basis in the hands of the donee is the same as it was in the hands of the donor. Property acquired from a decedent’s estate generally takes a stepped-up basis. “Stepped- up basis” means that the basis of property acquired from a decedent’s estate generally is the fair market value on the date of the decedent’s death (or, if the alternate valuation date is elected, the earlier of six months after the decedent’s death or the date the property is sold or distributed by the estate). Providing a fair market value basis eliminates the recognition of income on any appreciation of the property that occurred prior to the decedent’s death and eliminates the tax benefit from any unrealized loss.

Efforts to Eliminate Step-Up in Basis

President Biden has repeatedly called for eliminating the step-up provision, but Congress has frowned on the proposal. The White House calls this provision a “loophole that enables the capital gains of the very wealthy to go untaxed forever.”

The Tax Foundation says the step-up rule primarily affects taxpayers in the top 20% of the IRS tax brackets, especially those in the top 1%. The idea of closing this so-called “angel-of-death loophole” has drawn both criticism and praise.