Stepped-Up Cost Basis Rule
Stepped-Up Cost Basis – Very Important Tax Benefit
Practically all married couples have their home and other assets titled jointly with a right of survivorship. What that means is that when one spouse passes away, their ownership of the home or other asset passes on to the surviving spouse. This triggers a tax benefit called stepped-up cost basis.
This arrangement works very well for married couples who have a modest estate and want all of their assets to pass on to the surviving spouse. In most situations, these assets will pass to the surviving spouse without any federal or state death taxes. Plus, there is no need to get involved with lengthy and complicated estate or probate procedures.
What often happens though, the surviving spouse and/or inexperienced executors overlook a very important tax benefit that the survivor is qualified for. Perhaps because the joint ownership rules are so simple, this fact doesn’t surface.
A home, for instance, may have been purchased by the couple at very low cost many years ago. Over the years, it may have increased in value substantially, and at the date of death of the first spouse, may have a high fair market value.
Step-Up in Basis Can Result in Substantial Tax Savings
This is where the stepped-up cost basis rules come into play. When the first spouse dies, his/her cost basis in the home changes. Usually, an appraisal is done as of the date of death, and one half of the appraisal amount becomes his/her new stepped-up cost basis.
The surviving spouse inherits the deceased spouse’s new cost basis and adds it to his/her 50% of the original cost. This, in effect, will reduce income taxes, should the gain on the sale be higher that the exclusion amount when the home is eventually sold. Unfortunately, many taxpayers aren’t aware of this change in basis, and pay income taxes on gain that could have been avoided.
This stepped-up cost basis applies to other capital assets that you own such as stocks and bonds, valuable collectible items, that when sold, are subject to income taxes at capital gain rates.
The step-up in basis rules applies to capital gain assets that you inherit. The property inherited will have a cost basis based on the fair market value as of the date of death of the decedent, not what the deceased individual paid for it. This rule is covered in the IRS Code Section 1014(a).
Stepped-Up Basis for Inherited Property
You don’t often see a section of the IRS code that actually helps many taxpayers, but this one in particular stands out. A capital gain asset that appreciates during the lifetime of a decedent on his/her portion of that asset, usually won’t be subject to the capital gains tax.
The following is an example showing how this rule works.
A husband and his wife purchased a condo in Ocean City 20 years ago, used only as a vacation home for the family. The cost was 70,000.00, and the property was titled jointly with right of survivorship. Their initial cost basis is 35,000.00 for the husband and 35,000.00 for his wife.
About 20 years later, the husband dies. The couple had a minimal estate, so the wife had a local experienced realtor establish a value on the condo as of the date of death. The realtor issued a letter to the wife stating that the value was 110,000.00 based on recent comparable sales.
The wife no longer wanted the condo for various reasons and decided to sell it. If she sells the condo for the full value of 110,000.00, she assumes that taxes will have to be paid on 40,000.00, which is the difference between the sales price of 110,000.00 and 70,000.00, the original cost.
But, is her assumption correct? She, and so many other taxpayers do exactly that, and overpay their taxes. The IRS doesn’t know what they paid for the condo, so they don’t question any of the numbers, because they have to assume that the wife knows the tax code.
Step-Up in Basis at Death of Spouse
Her assumption is not correct based on the stepped-up cost basis rules now in effect.
So, what then is their cost in this condo? If the wife files her tax return based on her assumption, she will pay capital gains taxes on 40,000.00.
The new calculation for the total cost of this condo is as follows: The deceased husband had an original cost basis of 35,000.00, and on the date that he died, it was increased to 55,000.00, which is one half of the fair market value of 110,000.00.
The new total cost due to the step-up in basis for the husband will be 55,000.00 which the wife inherits. Adding the wife’s original cost basis of 35,000.00 equals 90,000.00 as the new cost. This results in a taxable gain of 20,000.00, not 40,000.00.
The rule for the step-up in basis is found in the tax law, Title 26, US Code, Section 1014. You should be aware also, that in a community property state (there are 9), this rule is even better for the surviving spouse. Each party gets the step-up in basis.
We all can’t possibly know every aspect of the current tax code, but when inheriting assets or receiving taxable gifts, it’s a good idea to seek experienced professional help.
The stepped-up cost basis rules are there to help you to not overpay your taxes. If you have a situation like this, and are not familiar with the tax code, we strongly suggest that you have a professional prepare your tax returns.
Gust Lenglet is the CEO of HBS Financial Group, Ltd., an accounting & tax preparation firm in Maryland. He has more than 25 years of experience in the banking and financial industry. Gust started his career as a loan officer at a major national bank, and then moved on to become controller of a multi-state law firm. In recent years, he has written many financial articles that have been published on Ezine Articles and many websites.