Investments

What Is Stepped Up Basis

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

When I was a kid, my dad always told me that the only things we “had to” do in this world were eat, sleep, and pay taxes; everything else was up to us. As I became older, I discovered that he was accurate about a lot of things. You pay taxes every time you fill up your gas tank, drive to work, and buy anything at the shop. You also pay income tax on the money you make.

The tax ramifications of your selections should be thought about at any stage of estate planning. After all, you wouldn’t want your heirs to have to pay too much in estate taxes out of the money you leave them.

While you may have heard that the ultra-wealthy take advantage of tax loopholes to generate tax savings, you may be shocked to learn that anybody with financial assets may easily take advantage of one such gap in their estate planning.

Depending on who you ask, this is either the stepped-up basis loophole, the stepped-up basis rule, or the cost-basis loophole. You may call it what you want, but if you intend to leave investment assets to heirs, taking advantage of the loophole will lessen the blow when the Internal Revenue Service comes knocking after the transfer has been made.

What Is a Basis Step-Up?

Stocks, bonds, mutual funds, real estate, and other investment property can all benefit from a provision of the tax code known as the “stepped-up basis loophole” upon inheritance. This is due to the peculiarities in determining the tax on capital gains.

The Internal Revenue Service (IRS) taxes investors on the difference between the asset’s cost basis and its selling price (profits). Your cost basis is $10,000 if you purchase 100 shares of ABC stock at $100 a share. A capital gains tax of $5,000 would be due if you sold your stock for $15,000 after it increased in value to $150 per share and you sold it for $15,000.

Under the stepped-up basis rule, however, the cost basis of appreciated assets that are inherited is stepped up to their fair market value as of the original owner’s date of death. To the Internal Revenue Service, the successor received the assets at their fair market worth at the time of the transfer, not at their original cost.

Therefore, inheritors do not have to pay capital gains taxes on the increase in value of the asset that occurred during the life of the original owner; they only have to pay taxes on the increase in value that occurred after the assets were passed to them.

The Stepped-Up Basis Loophole in Action

Stepped-up basis loopholes are easiest to understand when an example is provided to illustrate their operation.

As part of his bequest, Joe intends to give his heirs 1,000 shares of ABC stock. Joe’s original investment in these shares was $100,000 (100 shares x $100 purchase price). The stock has doubled in value during the previous decade, increasing in price from $100,000 to $200,000. His estate includes shares of ABC stock, and he can distribute them in one of two ways.

Option 1: Money Transfer (Voids the Stepped-Up Basis)

Joe’s initial choice is a wire transfer of money. At Joe’s passing, his ABC shares will be sold at a price reflective of their current market worth using this method. Estate tax on capital gains will be due at the standard rate upon liquidation. Let’s assume for the purpose of argument that rate is 15%.

The 15% tax would be withheld from Joe’s cash balance before it is given to his heirs. Given that Joe’s investment was initially worth $100,000 and had risen to $200,000 at his death, a tax of $15,000 would be owed on the $100,000 in profits at the 15% capital gains rate.
Joe’s successor would thus be entitled to a net payout of $185,000.

Option 2: Asset transfer (Takes Advantage of the Loophole)

Joe can also leave ABC to his heir in its current form, which is the second choice. Consequently, his heir would receive a base increase. No monetary exchange would occur between Joe’s heirs and the company upon his passing; instead, Joe’s shares in ABC would be handed directly to them.

Joe’s heir would profit from the Internal Revenue Service recalculating the cost basis of the shares based on their market value as of the date of transfer. What this implies is that Joe’s successor will receive $200,000 in shares instead of $185,000 in cash.

The inheritor can sell the shares for $200,000 without incurring any taxes. The stock’s cost basis was “stepped up” by the IRS from zero to $200,000, so the heir’s sale did not result in any capital gains.

Why is this rule in place?

Step-ups in basis are a common part of inheritance tax planning for the wealthy, although they weren’t originally intended to help them avoid taxes. Many people think that the extremely wealthy take advantage of this system.

The stepped-up basis rule was established so that families who owned farms and other enterprises could continue to pass them down from generation to generation without having to sell because of high tax rates.

Before the loophole was established, for instance, if Joe wanted to leave his farm to his son, he could, but the son would have to pay capital gains taxes on the whole rise in value of the land from the date Joe first held it. In other cases, the inheritance tax was so high that the heirs had to sell the family business to cover it.

Joe was able to leave his farm to his kids tax-free because of the stepped-up basis rule, which essentially meant that the property’s cost basis would be modified to reflect the fair market value on the date of Joe’s death.

Stepped-Up Basis Criticism

The stepped-up basis rule has been under investigation in recent years despite the fact that it has done wonders for many heirs of family-owned businesses, allowing them to continue to exist and be controlled by the family to this day.

Some have argued that the existing rule is unjust to the common citizen since it gives millionaires and billionaires an unfair opportunity to cheat the system. That’s not to say the counterargument is without merit.

For the ultra-wealthy, the stepped-up basis rule provides a tremendous incentive to accumulate wealth through the purchase and long-term storage of assets until death. When the ultra-rich go through this procedure, they can leave behind hundreds of thousands, if not millions, more than they would if their estates cashed out their investments and paid long-term capital gains taxes.

Then why is that a bad idea?

A staggering 30.4% of U.S. wealth is held by the top 1% of earners, according to Forbes. Two major repercussions ensue if these persons keep their wealth in assets like stocks and real estate and give their successors a step-up in basis:

It deprives the US government of billions of dollars in tax revenue.

The United States Federal Government runs on tax revenue. MarketWatch estimates that the total wealth of American households is at $142 trillion. In dollar terms, this equates to more than $43 trillion, or 30.4% of the total wealth in the United States being held by the richest 1%.

The United States government would collect an additional $4.3 trillion if the inheritance tax on $43 trillion was only 10%. The typical American’s tax burden might be reduced by $4.3 trillion if the federal government didn’t have to collect it from other sources, such as income taxes. The vast bulk of that money, however, is able to pass through as investment assets thanks to this loophole and so avoid taxation.

It deprives the American economy of spending.

Many of the rich take advantage of this tax loophole by investing a big portion of their fortune in assets they plan to keep until death. To put it another way, there’s funding that might be put to use fostering economic growth.

Of course the ultra-wealthy won’t blow their whole fortune on frivolous purchases. By acting in this way, they would be wasting their money. On the other hand, if this loophole that keeps so much money in investments were closed, the country’s already-wealthy citizens may spend more freely, expanding economic prospects for everybody.

Proposals to Close the Tax Loophole for Stepped-Up Basis

In response to public outcry against the stepped-up basis tax loophole, many lawmakers, particularly those affiliated with the Democratic Party, are rushing to amend the tax legislation. Vice President Joe Biden has put out a number of plans to close the loophole, but they have not yet been put to a vote in Congress.

There is currently no specific timetable for a vote on the American Families Plan (AFP), which is Biden’s proposal to close the loophole. Yet, if it is successful, it will be a tremendous victory for the Biden administration. The plan’s goals are to increase economic mobility for all Americans by expanding tax relief to middle- and lower-income households, expanding access to higher education, and bolstering paid family and medical leave and child care.

These advantages are appealing in theory but prohibitively costly in practice. Biden’s tax plan relies heavily on the partial closure of the stepped-up basis loophole for revenue. If the proposal is implemented, the exemption for inheritances over $1 million will be closed. The concept provides alternative safeguards for the transfer of family farms and other forms of family-owned enterprise.

Bottom Line

Countless American households take advantage of the stepped-up basis tax break while making their estate plans. It’s true that this loophole protects many Americans from crushing inheritance taxes, but critics argue that it gives an unfair advantage to the ultra-rich and prevents them from paying their fair share of taxes, which in turn deprives the government of revenue and the economy of a significant boost.

There may be skeptics, but the fact that the loophole is still open at the moment should not be forgotten. It should be factored into your estate planning decisions as long as it exists.

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