“Step up” in basis is a strategy that is used for avoiding capital gains taxes when an asset is passed on to the heirs upon death. The heirs receive a basis in inherited property equal to its date of death fair market value. Hence the difference between its original cost to the deceased taxpayer and the value at the date of death that is passed on to the heirs which would essentially be capital gain is avoided.
The fair market basis rule is only applicable to inherited property that’s part of a deceased person’s estate and also to property inherited from foreign persons who are not subject to US estate tax. It does not matter if a federal estate tax return is filed. Also, only the inherited portion of property owned by inheriting taxpayer jointly with the deceased is eligible for stepped up basis. It does not apply to the portion that the inheriting taxpayer already owned jointly with the deceased (note, there are special exceptions for community property transferred to a surviving spouse).
If a property is gifted before the death of a taxpayer, then the step up in basis does not kick in for such property. The value acquired by gift is subject to a “carryover” basis which means the basis for the person receiving the gift stays the same as the basis for the person giving the gift.
Sometimes there is step “down” in basis as well where the value of a property depreciates over time, and it is best to sell that property before death so that the owner can take advantage of the tax benefits of any potential loss.
Important update regarding this rule
As part of the proposed tax law changes under the Biden administration, the ability to step up the basis for gains of more than $1 Million ($2 Million for a married couple) might go away. Property donated to charity, family-owned businesses, and farms will most likely be exceptions to this change. Other unspecified exceptions could also apply. At the moment, these are just proposals and have not been approved by Congress yet. We will try to keep everyone posted about this proposed tax law change. Please feel free to reach out to us for any questions on estate planning or tax issues arising from inheritance.