Among the tax provisions relevant to intergenerational wealth transfer, “Step-Up in Basis” holds a prime position. Resetting an asset’s tax basis to its fair market value upon the original owner’s death, the provision potentially eliminates capital gains taxes on appreciation that occurred during the owner’s lifetime.
With this mechanism offering a major advantage over alternative transfer methods, we’re going to take a close look at Step Up in Basis, how to implement the strategy effectively, and how Harness can make the process of wealth transfer more efficient for tax advisors and their clients.
Table of Contents
- What is a Step-Up in Basis?
- What assets are eligible for Step-Up treatment?
- Special considerations and exceptions
- Step-Up in Basis versus alternative strategies
- Potential legislative changes on the horizon
- How Harness can help
Key takeaways
- Step Up in Basis allows heirs to inherit appreciated assets with a cost basis reset to the asset’s fair market value at the time of death. This is a crucial advantage over lifetime gifting, which transfers the original basis.
- The benefits are most dramatic for assets held for a long time with substantial appreciation, like real estate, long-held stocks, and business interests. Even a modest portfolio can yield significant tax savings.
- Most individual, taxable assets like real estate, publicly traded securities, and private business interests qualify. However, retirement accounts (IRAs, 401(k)s) and annuities generally do not, and certain complex trust structures require careful planning to qualify.
- Tax advisors need to understand special considerations like the “double step-up” in community property states, the alternate valuation date, and the “gift-back” rule.
- Tax advisors need to carefully monitor ongoing legislative discussions regarding potential changes to this provision, as this area is frequently targeted for reform.
What is a Step-Up in Basis?
Step-Up in Basis is a tax adjustment that allows beneficiaries to inherit assets without the latent tax liability on all gains accrued during the original owner’s lifetime. Imagine a stock purchased for a low amount decades ago that has since soared in value—without a step-up, the heirs would face substantial capital gains taxes upon sale.
The step-up effectively erases the taxable gain that accumulated before inheritance, creating a significant tax advantage compared to gifting assets during one’s lifetime, which typically transfers the original (low) cost basis to the recipient. For high-net-worth clients with substantial appreciated assets, this provision can represent millions in potential tax savings across generations.
What assets are eligible for Step-Up treatment?
Real estate holdings typically represent one of the most common and valuable step-up opportunities due to their long holding periods and substantial appreciation potential. A family home purchased decades ago for a fraction of its current market value can transfer to heirs without capital gains tax on the pre-death appreciation.
Stocks, bonds, and mutual funds held in taxable brokerage accounts also qualify for step-up treatment. However, it’s important to note that assets held in IRAs and 401(k)s follow different tax rules, generally subject to ordinary income tax upon distribution to beneficiaries, rather than receiving a basis step-up.
Business interests, including shares in privately-held companies, partnerships, and sole proprietorships, can receive a step-up. This presents significant planning opportunities for business succession, allowing heirs to sell or continue the business with a significantly reduced tax burden on accrued appreciation.
Collectibles like art, jewelry, and antiques also qualify for basis adjustment, which is particularly valuable given their higher 28% capital gains tax rate. This allows heirs to realize major value from such assets without incurring substantial tax liabilities.
That said, certain assets are notably excluded from step-up benefits, including retirement accounts (as mentioned), annuities, and assets held in specific types of irrevocable trusts (e.g., those designed to be outside the grantor’s taxable estate).
Special considerations and exceptions
There are a number of complexities within the Step-Up in Basis provision that advisors need to be aware of.
Step-Up in Basis when spouse dies
Community property states like Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, Wisconsin, and Alaska offer an enhanced “double step-up.” In these states, when one spouse dies, both halves of jointly-owned marital community property receive a basis adjustment to the fair market value, not just the decedent’s half.
Alternate valuation date
The alternate valuation date provision allows estates to value assets six months after death instead of the date of death, but only if this reduces both the gross estate value and the estate tax liability. While not commonly used, it can potentially affect the stepped-up basis amount.
In addition to this, assets gifted within one year of death and then inherited back by the original donor (or their spouse) may be denied the step-up basis benefit under certain circumstances (IRC Section 1014(e)). This provision is designed to prevent schemes where a terminally ill person gifts appreciated assets, only to have them returned at death with a stepped-up basis.
Foreign assets
Foreign assets have complex treatment depending on tax treaties, the deceased’s residence status, and whether the assets are considered situated within or outside the United States. Tax advisors will need an in-depth understanding of the relevant international tax laws in these circumstances.
Generation-skipping transfer
Generation-skipping transfer (GST) tax considerations must be weighed alongside step-up benefits when planning for multi-generational wealth transfers. While the step-up reduces capital gains, the GST tax addresses transfers to beneficiaries two or more generations younger than the transferor.
Irrevocable trust Step-Up in Basis
With careful planning, the step-up provision can be used with certain irrevocable trusts, despite the general rule that trust assets not included in the grantor’s taxable estate do not qualify for basis adjustment. For example, a grantor retained annuity trust (GRAT) or an intentionally defective grantor trust (IDGT) structured to be includable in the grantor’s estate for estate tax purposes (even if not for income tax purposes) could allow for a step-up.
Step-Up in Basis versus alternative strategies
While Step-up in Basis is a potentially powerful provision, it’s not the only wealth transfer strategy available.
Gifting appreciated assets during lifetime eliminates future appreciation from the donor’s estate for estate tax purposes, but transfers the original low cost basis to the recipient. This means the recipient will eventually pay capital gains tax on all the appreciation, including that which occurred before the gift.
Charitable Remainder Trusts (CRTs) offer an alternative approach for highly appreciated assets, providing income streams to the donor or other non-charitable beneficiaries for a term of years or life, while removing the asset from the taxable estate. Upon termination, the remainder goes to charity.
Installment sales to intentionally defective grantor trusts (IDGTs) may outperform the step-up strategy for rapidly appreciating assets with significant growth potential, as they effectively “freeze” the asset’s value for estate tax purposes while allowing future appreciation to accrue outside the grantor’s estate.
Life insurance strategies can provide tax-free death benefits to offset potential estate taxes or income taxes when other considerations make retaining low-basis assets for a step-up impractical or undesirable.
Potential legislative changes on the horizon
Step-Up in Basis is the subject of fairly continual tax reform discussions. The growing federal deficit, coupled with wealth inequality concerns and increased political pressure, has led to a closer examination of preferential tax treatments for inherited wealth.
With the future of the Step-Up in Basis far from certain, tax advisors should include contingency planning when building strategies that are heavily dependent on the current step-up provisions. Staying informed through reputable sources like the Congressional Research Service, Joint Committee on Taxation, and professional tax organizations is highly recommended.
How Harness can help
From managing complex valuations for illiquid assets to staying ahead of potential legislative changes, implementing an effective Step-up in Basis can present major challenges for tax advisors. Moreover, the intricate interplay with other estate planning tools and multi-jurisdictional issues demands specialized knowledge. For busy advisors serving high-net-worth clients, managing these complexities efficiently can be a hurdle.
Harness directly addresses these issues by offering a powerful operational platform and a curated community of expert tax advisors. Through Harness, advisors can access peer-to-peer knowledge sharing, specialized resources, and secure client engagement tools, streamlining any number of complex tax planning processes, including Step-up in Basis. Our platform ensures advisors receive the ongoing support and advice needed to confidently administer wealth preservation strategies for their high-net-worth clients. Get started with Harness and explore new levels of tax practice efficiency and insight.
Disclaimer:
Tax-related products and services provided through Harness Tax LLC. Harness Tax LLC is affiliated with Harness Wealth Advisers LLC, collectively referred to as “Harness Wealth”. Harness Wealth Advisers LLC is a paid promoter, internet registered investment adviser. Registration does not imply a certain level of skill or training. This article should not be considered tax or legal advice and is provided for informational purposes only. Please consult a tax and/or legal professional for advice specific to your individual circumstances. This article is a product of Harness Tax LLC.
Content was prepared by a third-party provider and not the adviser. Content should not be regarded as a complete analysis of the subjects discussed. Although we believe the content is reliable, it is not guaranteed as to accuracy and does not purport to be complete nor is it intended to be the primary basis for financial or tax decisions.