The “step-up in basis” concept is a vital aspect that real estate investors (and inheritors) need to understand. Ideally, a step-up in basis adjusts the value of an asset to its fair market value at the time of the original owner’s death. This adjustment can significantly reduce capital gains taxes when the asset is later sold.
Many investors, especially those in community property states, consider this concept an opportunity – some professionals even going as far as calling it a tax loophole. Assets that qualify for this adjustment, particularly, community properties where both halves receive a stepped-up basis, can provide the surviving spouse with a major advantage. As we’ll see later on in the article, such concepts are usually difficult even for seasoned investors to fully understand. There is also a general lack of information about such complex property concepts.
But, if you are an investor looking to take advantage of such near-fringe concepts, then you can always visit the Buy NNN Properties Resources Page for a comprehensive breakdown of this or any other concept as it relates to commercial real estate. So now, let’s understand what a stepped-up basis really means:
What is a Stepped-Up Basis?
The concept of “stepped-up basis” revolves around the valuation of an inherited asset. When you inherit an asset, its “basis” (the value used to determine gain or loss for tax purposes) isn’t the original cost the deceased person paid. Instead, the basis is adjusted or “stepped up” to its fair market value at the time of the owner’s death. This adjustment is significant because capital gains taxes, when selling the asset, are calculated based on this new basis.
The stepped-up basis rule, therefore, often reduces the taxable gain on an inherited asset, potentially leading to tax savings for the inheritor. It’s an essential concept in tax and estate planning, ensuring that inheritors aren’t unduly burdened by capital gains taxes on asset appreciation that occurred before they came into ownership.
An Example of a Stepped-Up Basis in Action
Let’s take the example of John, who owns a beachfront property, but unfortunately dies and leaves her daughter, Emily the property as an inheritance. To simplify the calculation, we’ve also assumed that all other legal and tax requirements on the property have been met.
Original Purchase:
John bought a beachfront property in 1990 for $100,000. This amount ($100,000) is the original basis of the property.
Time of John’s Passing in 2030:
By the time of John’s death in 2030, the beachfront property, due to various factors like development in the area and inflation, had appreciated to a market value of $500,000.
Stepped-Up Basis:
When John’s daughter, Emily, inherits the property in 2030, she doesn’t take on the original basis of $100,000. Instead, her basis is the property’s fair market value at the time of John’s death, which is $500,000. This new value is called the “stepped-up basis.”
Sale of Property:
Suppose in 2032, Emily decides to sell the property. If the selling price is $550,000, here’s how the capital gains would be calculated:
Original basis for Emily (stepped-up basis): $500,000
Sale price: $550,000
Taxable capital gain: $550,000 (sale price) – $500,000 (stepped-up basis) = $50,000
Comparison Without Stepped-Up Basis:
For more clarity, let’s compare what the capital gains tax would’ve been if the stepped-up basis rule didn’t exist. If Emily had to use John’s original basis:
Original basis (John’s purchase price): $100,000
Sale price: $550,000
Taxable capital gain: $550,000 (sale price) – $100,000 (original basis) = $450,000
With the stepped-up basis rule, Emily’s taxable gain is $50,000. Without it, she would have a taxable gain of $450,000. The stepped-up basis, therefore, saved Emily from potentially paying capital gains tax on an additional $400,000.
This example underscores the financial impact of the stepped-up basis, especially in assets that have appreciated considerably over time. It’s a pivotal tax provision that can significantly influence the decision-making process surrounding inherited assets.
What Assets Do Not Get a Step Up in Basis?
It’s important to know that not all inherited assets are eligible for a step-up basis. Assets such as retirement accounts, including IRAs and 401(k)s, do not receive this step-up. The primary reason for this exclusion is the tax-deferred nature of these accounts. Instead of getting a basis adjustment, distributions from these accounts are treated as taxable income to the beneficiaries, preserving the government’s ability to tax the deferred income upon distribution. Here is a list of some assets that do not receive a step-up in basis.
Retirement Accounts:
When it comes to assets that don’t receive a step-up in basis, retirement accounts stand out. Assets held within traditional IRAs, 401(k)s, and other retirement accounts don’t get a step-up in their tax basis. Instead, distributions from these accounts are typically treated as ordinary income. This means, for instance, if you inherit a traditional IRA, any money you withdraw will be subject to regular income tax rates, not capital gains tax. Consulting with an estate planning attorney can offer guidance on how best to handle these assets.
Income in Respect of a Decedent (IRD):
Income in respect of a decedent represents money the deceased was entitled to but did not receive before their death. Examples include unpaid wages, retirement account distributions, or interest. This income does not get a step-up in basis. The beneficiary must report this income and pay taxes based on its original value, adhering to guidelines from the Internal Revenue Service (IRS).
Jointly Owned Assets:
In some scenarios, jointly owned assets might not receive a full step-up in basis. In many states, if a property is owned jointly with rights of survivorship, only half of the property (the deceased person’s half) gets a step-up in basis upon death. The original cost basis remains for the surviving owner’s half. It’s a nuanced area and varies, especially in community property states. Therefore, it’s essential to consult an estate planning attorney for clarity.
Gifted Assets:
If an asset is gifted before death, it retains its original cost basis. For example, if a parent gifts stock from a brokerage account to a child, the child assumes the original cost basis of the stock. If the stock is later sold, capital gains tax will be calculated based on this original cost. Gifted assets do not enjoy the benefit of a stepped-up basis like an inherited asset would.
Certain Trust Assets:
Trusts can be a bit complex. Some assets held in specific types of trusts might not get a step-up in basis upon the grantor’s death. The exact tax implications depend on the nature of the trust, its terms, and other assets it holds. Given the intricacies of trusts, always seek advice from an estate planning attorney when navigating these waters.
Understanding Why Some Assets Can Not Receive a Step-Up
Traditional retirement accounts, such as IRAs and 401(k)s, don’t receive this step-up because they’re designed to offer tax benefits during the contributor’s life, ensuring that withdrawals are taxed as ordinary income. Similarly, Income in Respect of a Decedent (IRD) doesn’t get a step-up in basis to ensure that income the deceased was entitled to but didn’t receive before passing remains taxed.
For jointly owned assets, the rationale behind their partial step-up in basis hinges on ownership percentages. In many non-community property states, only half the asset, the portion that belonged to the deceased, gets this step up to its fair market value. However, community property states recognize assets acquired during marriage as equally owned, enabling both halves to benefit from a stepped-up basis. This distinction is crucial for a surviving spouse when considering potential capital gains taxes upon sale.
Gifted assets and certain trust assets are other exceptions to the step-up rule. Assets that are gifted retain their original cost, preventing a potential tax loophole where gifts might be used to avoid taxes. Because of the complex nature of trusts, they might not always allow assets to receive a stepped-up basis, primarily if they’re designed to freeze asset values for estate tax purposes.
Is Step-Up in Basis a Tax Loophole?
While the step-up in basis can help heirs reduce potential taxes on sales of inherited assets, calling it a “tax loophole” is a matter of perspective. Some see it as a necessary provision to prevent heirs from facing burdensome tax bills tied to the original purchase prices of assets. Others argue that it allows wealthy individuals to pass on assets without paying their fair share in taxes.
Regardless of the viewpoint, it’s crucial for individuals to understand their personal situation. If you are considering more complex estate planning strategies involving irrevocable trusts, it’s paramount to consult a qualified professional to ensure alignment with your financial goals so that you can efficiently navigate potential future legislative changes.
The Implications of Step-Up in Basis for Real Estate Investors
To the dedicated real estate investor, the concept of a step-up in basis isn’t a minor detail. It’s a foundational aspect of personal finance that can play a pivotal role in shaping your investment strategy. The interplay between the step-up in basis and real estate investments can have profound tax implications, and understanding this relationship is vital to maximizing your returns and ensuring your assets are managed prudently.
Reducing or Avoiding Capital Gains Tax on An Investment Property
Imagine the implications for inherited property. A property that was purchased decades ago could have appreciated substantially. If you were to sell this property using the original purchase price as the cost basis, the capital gains taxes could be substantial. But with the step-up in basis, the cost basis adjusts to the market price at the time of the owner’s death, potentially allowing investors to sell at or near this new basis and avoid capital gains taxes.
Potential Relief From Double Taxation in Community Property States
Now, if the property in question is located in a community property state, the tax advantage can be even more significant. Here, a mechanism known as a double step-up can come into play. In these states, if one spouse passes away, both halves of jointly-owned property, like primary residences, can receive a step-up in basis. This dual adjustment can provide significant relief from double taxation, particularly when the surviving spouse later sells the property.
However, while the step-up in basis provides clear benefits for real estate, it’s important to note that not all assets receive the same treatment. Assets like tax-deferred annuities or mutual funds held outside a decedent’s estate might not benefit from this provision. This underscores the importance of having a comprehensive estate plan and understanding how different assets are treated for tax purposes. While considering such a concept when investing, align with a financial advisor who can offer a holistic view of your portfolio and help strategize how the step-up in basis can best serve your investment objectives.
Final Thought on Step-up Basis
The provision for a step-up in basis not only offers a potential respite from substantial capital gains taxes but also highlights the importance of strategic estate planning for investors inheriting or dealing with inherited property. It’s a testament to how intricate the pathways of property investment can be, and the ties between personal finance decisions and broader tax structures.As you chart your course in real estate investing, always prioritize continuous learning and consultation. The landscape of tax laws and estate planning is dynamic, and staying informed is your best defense against unforeseen financial challenges. Do you need more information about the step-up basis concept? Are you an investor looking to maximize the benefits of such concepts? Consult with NNN Deal Finder today.