You’re about the hear a lot more about the “stepped-up basis” (loophole) in the coming weeks (it’s part of President Biden’s proposal for the American Family Plan) and if it’s not something you’re familiar with, here’s a quick explainer.
Are you familiar with capital gains tax? When you buy an asset and sell it for more, you pay taxes on how much the asset has gained.
If you buy a stock of Best Wallet Hacks for $10 (it’s a great deal!) and then sell it for $15 (noooooo!), you owe capital gains tax on the $5 in profit. If you held it for more than a year, you pay long-term capital gains tax rates. If you hold it for less than a year, you pay short-term capital gains tax rates.
Your original cost basis is $10. You sell it for $15 with a profit of $5. You owe taxes on the $5. (if you pay commissions on the trade, you can deduct those costs but there are plenty of commission-free brokerages that I can’t find a reason you should be paying a commission.)
But what happens when you die?
You have a cost basis but you never sell the assets, so how do they determine how it should be taxed?
That’s when the stepped-up basis comes in.
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What is Stepped-Up Basis?
When you die and pass on assets to your heirs, the cost basis of the asset to your heirs is “stepped-up” to the current market value at the time of your death. It is also sometimes referred to as a “step up in basis.” The two mean the exact same thing.
For the above example, your heirs will get the share of stock in Best Wallet Hacks and their cost basis will be “stepped-up” to $15.
It doesn’t matter that your cost basis was $10 – theirs is $15. When they go to sell, they owe taxes on the amount over $15 per share, their new cost basis.
It’s Actually a “Reset” of Basis
Technically, the basis can go up and down relative to the original basis. If your asset loses value, you get the lower market value. If it goes up in value, you get the higher market value as the new cost basis. (well, technically your heirs do)
People only ever talk about the step up because you almost never have a step down.
If you know your market value is lower than your cost basis, then you’d want to realize the loss before death so you can get a deduction for the loss. The only exception to this would be if you somehow didn’t know or lost track of your assets.
What About Estate Taxes?
Your heirs may get the new basis but they may also owe estate taxes on their inheritance.
For 2021, federal estate tax kicks in for estates worth more than $11.7 million (for individuals, $23.4 million for married couples). The rates then range between 18% and 40% depending on the amount being taxed. So when you pass along assets to your heirs, their market value is used to determine estate taxes. At the federal level, it only kicks in at $11.7 million.
Most states do not charge an estate or inheritance tax and when they do it’s likely lower than the federal levels. For example, in Massachusetts, any assets over $1 million inherited are subject to estate taxes at rates between 0.8% and 16%.
You’ll want to look up the rules in your own state but here’s a good place to get the basics.
So while the cost basis to your heirs will step up, they might owe taxes on the entire asset if your estate is large enough.
The other catch is that not every asset is eligible for a step up. There are things like IRAs and 401(k)s where the cost basis is largely irrelevant because of how the account is structured. Since Traditional IRAs and 401(k)s are tax-deferred, you owe taxes on the distributions and there’s no concept of “gains.” Since you could deduct contributions to those accounts, you would’ve paid income taxes on all of the distributions so there’s no basis to step up.
Is This Really a Loophole?
It’s sometimes called a “stepped-up basis loophole” but I’m not convinced this is a loophole and really just a benefit that helps a (very) small group. The people who really benefit fit a relatively narrow band – you have to be quite rich.
A Tax Foundation analysis noted that it “almost exclusively affects taxpayers in the top 20 percent.” It’s also “four times larger for those in the top 1 percent relative to those in the top 20 percent.”
20% may seem like a large group but that’s just who is impacted and not who actually will pay more in taxes as a result.
Next, you have to die! Without death, there’s no step up in basis to apply. And not only that, you have to die without any estate planning in place to avoid some of the estate taxes. It’s really not that great of a loophole. 🙂
Calling it a loophole makes it seem like there’s something dodgy you have to do but it’s really spelled out quite clearly – just die and your heirs get the higher basis!
Another aspect of this is that it only affects those who don’t avoid estate taxes through the use of trusts.
What Would Happen if it’s Repealed?
The existence of this stepped-up basis means that people are less likely to sell appreciated assets because those paper gains get realized without any tax implications. As the original owner, you may not realize the benefits but your heirs do.
If it were repealed, then more people who sell those appreciated assets and more capital gains tax would be collected. The government gets more revenue.
Step-up Basis Example
Let’s say you have stocks that you purchased for $250,000 and when you die they are worth $500,000. Two years after your death your heirs sell the stocks for $520,000. We’ll also assume that your estate is worth less than $11.7 million.
Right now your heirs would pay nothing in federal estate taxes but would pay long-term capital gains on the $20,000, which would probably be $3,000.
Capital gains taxes rare 0%, 15%, or 20%. Most people will likely fall into the 15% rate. (Income between $40,401 and $445,850.) States have their own rules about capital gains.
If this “loophole” is repealed your heirs still would not pay federal estate taxes but would pay long-term capital gains on $270,000 – the amount from your purchase price to their sale price. Assuming they still qualify for the 15% long-term capital gains rate they would pay $40,500 in federal taxes.
Should it be Repealed?
I don’t think there’s any moral or financial or philosophical argument you can make in favor or against the step-up in basis rule. It speaks more about the state of estate taxes than anything else.
I suppose repealing it could result in double taxation – you get the capital gains tax on the asset itself and then the amount gets taxed again as the estate is settled – but that would be it.
Either way, there you have it – the step up in basis loophole in a nutshell. 🙂