Understanding the Step-Up in Basis Rule

IRC Section 1014 contains one of the most well-known and favorable rules for taxpayers, offering significant benefits for heirs inheriting appreciated assets. This rule allows for a “step-up” in the basis of inherited assets to their fair market value as of the date of the decedent’s death. In essence, it resets the cost basis of these assets to their current value at the time of inheritance, thereby eliminating any potential capital gains taxes that would have been incurred if the assets were sold by the decedent during his or her lifetime. 

This means that if the beneficiary chooses to sell the inherited assets after they receive it, they would only be subject to capital gains taxes on the appreciation that occurs after the date of inheritance, rather than the entire appreciation since the assets were originally acquired by the decedent.

Example:

For example, suppose an individual inherits shares of stock from a deceased relative. If the stock was originally purchased by the decedent for $10 per share and has appreciated to $50 per share at the time of inheritance, the beneficiary’s new basis under IRC Section 1014 would be $50 per share. If the beneficiary later sells the stock for $60 per share, they would only be liable for capital gains taxes on the $10 per share appreciation that occurred after the date of inheritance, rather than the full $50 per share gain ($60 amount realized minus new stepped-up basis of $50, rather than the decedent’s original basis of $10).

The so-called “step-up rule” greatly affects everyone, not just the wealthy.  Even modest estates may contain highly appreciated assets such as stocks, real estate, or other investments, especially if Grandma held on to it for a really long time.

Planning Opportunities with the Step-Up Rule

Many estate planning attorneys, financial advisors and individuals can use the step-up rule in their favor as a planning technique to effectively eliminate capital gains taxes in the thousands to hundreds-of-thousands of dollars, or even more, depending on how much the assets have appreciated.

Simple Tax Planning Strategies

A sophisticated, yet simple, technique may be to intentionally hold onto highly appreciated assets during your lifetime, so that upon death, your heirs will receive the property with the new, stepped-up basis. This may go against the advice of your financial advisor, who may want to “churn” stocks and other investments in an attempt to actively manage or diversify a portfolio. Yet sometimes you may wish to tell the advisor that you want to hold on to that stock lot you’ve held onto for twenty years and instead pass it on to your children.

Additionally, many people may want to intentionally cause the inclusion of appreciated assets in their gross taxable estate, rather than trying to remove it. With the estate tax exemption amount being as high as it currently is ($13.61 million per person in 2024), most people will not be subject to the estate tax upon their passing.  For a married couple with a modest, yet substantial net-worth of a few million (think of your average “millionaire-next-door” of maybe $4 or 5 million), all of the couple’s assets can be safely included in either of their gross taxable estates, without incurring any additional estate taxes. The combination of the high estate tax exemption and the step-up rule creates a new playground of planning techniques available to people.  

Advanced Tax Planning Strategies

For example, if one spouse is in poor health and his/her life expectancy is limited, an appreciated asset could be placed in that spouse’s sole name. This would enable the surviving spouse to receive it again and subsequently sell it, without worry about income tax considerations. However, the step-up rules requires that if you receive property by gift, you have to hold it for one year before your death before your heirs can reap the benefit of the step-up in basis rule. 

Another sophisticated opportunity is to exercise a special “swapping power” to swap highly appreciated assets out from an irrevocable grantor trusts, back into the decedent’s estate, in exchange for cash or cash equivalents (which, of course, already has a high basis equal to its value). 

Yet another sophisticated strategy may be to claim that the decedent had a retained interest under IRC Section 2036, using it as a sword instead of a shield, to seek the inclusion of a previously gifted asset. This would cause the asset to receive a stepped-up basis in the hands of the beneficiary, without incurring any additional estate taxes. 

Conclusion

Most people are concerned about minimizing the overall taxes that will be imposed at their passing. By employing strategic planning techniques, proper estate planning can minimize the burden of taxes, enabling future generations to receive and keep more assets. If you are interested in doing a deep dive into how you and your family can save in overall taxes, please contact our office to speak with our attorney.

Written By Laura C. Rivers, J.D., LL.M.