An inheritance can present unique financial opportunities with respect to the inherited assets' cost basis and subsequent tax obligations. The "cost basis step-up," which adjusts the value of an inherited asset for tax purposes, has the potential to significantly reduce capital gains tax when the beneficiary decides to sell the inherited asset.
In This Insight
What does cost basis mean?
How cost basis adjustments impact estate planning
What does cost basis mean?
Cost basis refers to the original value of an asset for tax purposes. In simpler terms, it is the price paid to acquire the asset and forms the starting point when calculating capital gains taxes upon the sale of the asset. Normally, the cost basis includes the purchase price and other associated costs such as commissions and improvements. Depending on your specific financial situation, understanding the cost basis can play a key role in tax planning.
Cost basis refers to the original value of an asset for tax purposes, adjusted for items such as commissions and improvements.
Inheritance and its Impact on Cost Basis
When assets are inherited the cost basis for those assets adjusts to the fair market value of the asset on the day of inheritance. This is often referred to as a cost basis step-up.
In contrast to the cost basis, which is typically the original purchase price of the asset, the step-up basis becomes the market value of the asset at the time of the original owner's death. Capital gains tax on the sale of the asset by the inheritor is then calculated based on the step-up, not the original cost.
The step-up in basis is an essential tax advantage that can significantly reduce the burden on heirs who would otherwise have to pay capital gains tax on the total amount the asset has appreciated since its original purchase. For example, if a parent bought a house for $100,000 fifty year ago and it is now worth $500,000, the child inheritor would potentially face capital gains tax on $400,000.
With the step−up in basis, the child′s starting point is $500,000, facing no capital gains tax unless the property's value increases before sale.
However, it's important to note that this rule works both ways. While the adjustment of inherited assets are often stepped-up, they can also be stepped-down. When inheriting assets, it would be more appropriate to say "step-to", meaning the asset steps up or down depending on how the value change between the original purchase and the date of death of the grantor.
The cost basis adjustment for inherited assets would more appropriately be called a "step-to" than a "step-up", but more often than not assets are stepped up in value.
Step-Up in Cost Basis: An In-depth Explanation
A step-up in cost basis is an essential concept to understand for individuals who have inherited an investment like real estate or stocks. Generally, the cost basis of an asset is its original purchase price. However, when an asset is received as an inheritance, the basis changes. In this case, the cost basis becomes the fair market value of the asset at the original owner's date of death, rather than what the deceased initially paid.
This cost basis adjustment can have a profound impact on the potential capital gains tax owed if the inherited asset is later sold. Let's say you inherit a property that was purchased for $100,000, but its value at the time of the original owner′s death is $200,000.
If the property is sold for $250,000, the taxable gain isn′t $150,000 (the selling price minus the original cost). Instead, it's only $50,000, based on the stepped-up basis.
Admittedly, quantifying a precise step-up in basis can be tricky as it requires establishing the fair market value at the time of death accurately. This often requires appraisals or valuations, which can involve additional cost. But in many cases, the dollar savings in capital gains tax can significantly outweigh any additional expenses incurred in establishing the step-up in cost basis. Proper attention to details and possibly working with a tax professional can help manage this process more effectively.
Example of Cost Basis Step-Down After an Inheritance
As mentioned previously, the cost basis adjustment can go both ways. Imagine an instance where an investor inherits a property that was bought for $100,000. At the time of the benefactor′s death, the property value has decreased to $80,000. Rather than the original cost basis of $100,000, the inheritor’s cost basis will step down to the current market value of $80,000. This change effectively mitigates potential capital gains taxes if the inheritor decides to sell.
In the event the inheritor sells the property for $100,000, they would be subject to a $20,000 capital gain, despite the original purchase price also being $100,000.
How Cost Basis Adjustments Effect Estate Planning
The step-up in cost basis can influence decisions regarding the liquidation of assets. When beneficiaries inherit assets such as stocks, real estate, or other investments, the adjusted cost basis can often reduce potential capital gains tax liability.
This means that, if a beneficiary decides to sell an inherited asset shortly after receiving it, they may owe less in taxes compared to if they had received the asset as a gift during the lifetime of the original owner. As a result, individuals creating an estate plan might opt to hold onto certain appreciating assets, knowing their heirs will benefit from the step-up provision and thereby minimize tax implications upon sale.
The step-up provision can impact the choice of assets to bequeath. Since the step-up in cost basis resets the value of the asset to its fair market value at the time of the original owner's death, it may be more advantageous for individuals to leave assets that have significantly appreciated in value to their heirs, rather than gifting them during their lifetime.
This strategy can be particularly beneficial for assets that have experienced substantial growth over time, as the potential capital gains tax upon sale would be based on the stepped-up value, rather than the original purchase price.
The step-up in cost basis also serves as a consideration when determining the structure and timing of trusts and other estate planning vehicles. For instance, some trusts are specifically designed to take advantage of the step-up provision, ensuring that assets within the trust receive a step-up in basis upon the grantor's death.
On the other hand, assets placed in certain types of irrevocable trusts might not benefit from the step-up provision. Therefore, it's crucial for individuals to consult with estate planning professionals to navigate these complexities and optimize the benefits of the step-up in cost basis for their unique situations.
Schedule a Free Consultation with Selective
Maximizing the value of your wealth is a complex task that requires expertise across a variety of disciplines. Schedule a free consultation with an advisor that provides comprehensive wealth management, which includes financial planning, investment management, tax strategies, estate planning, and insurance services. Schedule a free consultation today.
Final Thoughts
Inheritance can have a significant impact on the cost basis of an asset, specifically through the step-up provision. It’s crucial to fully comprehend this concept to navigate the tax implications intelligently. Inherited assets can receive a new cost basis, essentially the market value of the asset at the time of the original owner’s death. The step-up can lower tax burdens for beneficiaries significantly when they sell the inherited property. However, the tax implications of the cost basis step-up vary depending on the specific scenario, so it's advised to consult with a tax professional or an attorney to ensure an accurate understanding and application of these rules.