The Importance of the Step-Up Basis Rule

Before Congress enacted legislation a few years ago dramatically increasing the estate exemption amount, the name of the game in estate planning was largely estate tax minimization or avoidance.  Now, the current exemption amount is $5,490,000 per individual in 2017, and spouses have the ability to double that amount under the existing rules which allow a surviving spouse to claim and utilize the unused portion of the deceased spouse’s exemption amount.  Only .2% of deceased individuals now face and have to pay an estate tax.  This has changed the game to where income tax planning is now the new primary focus. In estate planning, one of the income tax strategies is preserving or leveraging the step-up in basis.

What Is Basis? Basis can be described as the cost to acquire an asset. For example, if you purchase stock, your basis is the purchase price, plus costs and transfer fees.  Upon the sale of an asset, tax liability is calculated based on the increase from the basis to the sale price.

In estate planning, strategies concerning basis center around two important transfer of basis rules, which are “Step-up” basis and “Carry-over” basis.

Step-Up and Carry-Over Basis. Which transfer of basis rule applies depends on whether the asset is transferred to another during the owner’s life or upon the owner’s death.  Transfers by way of gift during the owner’s life have a Carry-over basis, meaning that upon the gift by the donor to the donee the donor’s basis in the gifted asset “carries over” to and becomes the basis of the donee.  If the donee then immediately liquidates the asset he or she is responsible for paying the taxed assessed on the capital gain realized on the sale which, as stated, is the increase from the basis to the sale price. In contrast, if upon the death of the owner the same asset is transferred to the same recipient or anyone else, the owner’s basis in the asset is stepped up to the fair market value at the date of death.  The recipient now has a step-up basis in the asset equal to the fair market value at the date of death, and an immediate sale of the asset at that value would result in no gain being realized and, thus, no capital gains tax.

To illustrate, suppose father purchased cabin recreational property for $100,000 and now, several years later, the property is worth $1 million. Father, who is widowed, has one child and father wants to give the land to his child as a gift.  Father seeks the advice of a knowledgeable estate planning attorney who discusses father’s options, including the transfer of basis rules.  Father decides that rather than gifting it now, he’ll wait and have the cabin property transfer to his child upon his death.  Father dies the next year and the child inherits the property.

Here, the step-up in basis rule would apply, and not the carry-over basis rule. The basis of the cabin property is stepped up from $100,000 to $1 million. The result is that the child can now sell that property, should the child choose to do so, at its stepped-up basis of $1 million with no capital gains liability.

Had father instead gifted the property to his child the carry-over basis rule would have applied.  The child would have carried over father’s basis of $100,000 and upon sale of the property would be responsible for paying capital gains on the asset now worth $1 million.

For a client who is considering making a substantial gift and whose estate falls under the $5,490,000 2017 estate tax exemption, giving early (before death) isn’t necessarily the most generous way to give. To minimize the income tax impact and to be sure that one’s beneficiary receives the most from an asset, it’s important to consider taking full advantage of the step-up basis rule.

Jon