“Step Up” Your Estate Planning Game

Understanding how the basis step up rule operates is important for navigating the complexities of estate planning and taxation, as it can significantly impact the financial outcomes of inheritances. The basis step up rule effectively wipes out any built-in capital gains when someone inherits an asset from a decedent. Because the amount of capital gains determines the amount of capital gains tax owed, basis step up is considered one of the most powerful and important tools in the estate and tax planning universe. Let’s examine the rule and some commonly encountered examples of when a basis step up will, and won’t, occur.

Basis step up simplified

Say an individual owns shares in a company with a fair market value (FMV) of $100,000. They acquired the stock many years ago for the purchase price of just $10,000, which is their acquisition cost and the cost “basis”. If shares are sold for the FMV of $100,000, they would owe capital gain tax on the $90,000 difference between the sale price and their basis.

However, what if they don’t sell the stock during their lifetime, but instead leave it to their child as an inheritance? Under Internal Revenue Code (IRC) Section 1014(a), the child will inherit the stock with a new, “stepped up” basis equal to the $100,000 FMV of the stock as of the date of the parent’s death. If they then sell the stock for its FMV of $100,000, no capital gain tax is owed on the sale because the difference between the sale price of $100,000 and the $100,000 stepped up basis is $0.

When basis step up applies

With very few exceptions, an asset will get basis step up if it’s subject to estate tax.[i] Basis step up can be thought of as the lollipop after the estate tax shot. The opposite is also true. If an asset was not subject to estate tax, then it will not receive a basis step up. No shot, no lollipop!

The estate inclusion requirement doesn’t mean that estate tax must be paid in order for a basis step up to apply; the asset simply has to be subject to estate tax (i.e., included in the decedent’s gross estate). Even if an estate is under the lifetime exemption amount and therefore owes zero in estate tax, the estate’s assets will still receive a basis step up because the assets were part of the estate tax calculation.

Determining fair market value

Code section 1014(a)(1) says that the new basis of an inherited asset is its “fair market value” at the date of the decedent’s death. However, the Code doesn’t provide specific guidance as to how that value should be determined. Fortunately, Treasury regulations and the IRS provide guidance for determining the FMV of some common asset classes, notably marketable securities. The instructions for Schedule B of Form 706 (Estate Tax Return) provide as follows:

The FMV of a stock or bond (whether listed or unlisted) is the mean between the highest and lowest selling prices quoted on the valuation date. If only the closing selling prices are available, then the FMV is the mean between the quoted closing selling price on the valuation date and on the trading day before the valuation date.

Cash, of course, doesn’t need to be valued since it’s always worth its face amount. Other common assets with a relatively low value (such as household effects, vehicles, clothing, etc.) may generally be valued using a good faith estimate. Artwork, collectibles, antiques, and other difficult-to-value or high-value assets may require a specialized appraisal. Real estate values must generally be substantiated by a qualified appraisal, which means that a formal appraisal by a licensed real estate appraiser should be obtained in most cases.

While the Code doesn’t say that a formal appraisal is required, doing so is generally advisable for practical purposes. A comparative market analysis or estimate from a real estate agent won’t have the evidentiary strength in the event of an audit as a formal appraisal would. Closely held businesses and nontraded securities will always require a formal valuation from a CPA or other specialist who is qualified in that area.

Full basis step up for community property

Community property is a form of ownership available to married couples in certain states. States that recognize community property ownership are generally called community property states, while states that don’t recognize this form of ownership are generally called common law states.[ii] A unique basis step up rule applies to married couples who own community property. It provides that any asset held as community property will receive a 100% basis step up at the first spouse’s death, even though half of the community property isn’t owned by the deceased spouse.[iii]

For married couples in common law states, ownership of assets acquired during marriage can be kept separate or owned jointly. When one spouse passes away, only the assets included in the deceased spouse’s estate will get a basis step up. That would be 100% of the deceased spouse’s separate property, but only 50% of jointly owned property since each spouse is deemed to own half of any joint assets. For married couples who own community property, as long as at least 50% of the community property is included in the deceased spouse’s gross estate (which would almost always be the case since each spouse is deemed to own 50% of community property), then not only does the deceased spouse’s share of the community property gets a full basis step up under the general rule of Code Section 1014(a), but the surviving spouse’s share also get a full basis step up under the special community rule of Code Section 1014(b)(6).

Basis step up for trust-owned property

Up to this point, we’ve discussed the basis step up rules in the context of property owned by an individual decedent that passes at death to one or more individual beneficiaries. However, in the estate planning world, what we see just as often (if not more so) is property owned not by individuals, but by various types of trusts.

How do the basis step up rules apply to a noncorporeal entity, such as a trust, that doesn’t die? The same rules are just as applicable to property owned by a trust as they are to property owned by an individual; it all still comes down to estate inclusion.

When a grantor transfers property to a trust, that property may or may not be included in the grantor’s estate at death. Take, for example, a revocable trust. When a grantor creates and funds a revocable trust, the revocable trust isn’t a separate taxpayer. Its assets and income are reported under the grantor’s Social Security number. The grantor is still the owner of the revocable trust assets for all tax purposes, including for purposes of calculating their gross estate.[iv]

Compare a revocable trust with transfers to an irrevocable trust, such as a Spousal Lifetime Access Trust (SLAT) or Irrevocable Life Insurance Trust (ILIT) where assets are not included in the grantor’s gross estate at death. With the irrevocable trust, the grantor has given up use and control of the assets to such an extent that they no longer fall within any of the categories that the Code uses to define a decedent’s gross estate.[v] So what does this have to do with the basis step up rules? Well, everything. If the assets in a trust are included in the grantor’s gross estate at death, then the assets will get a basis step up. If the trust assets aren’t included in the grantor’s gross estate at death, then the assets won’t get a basis step up (remember – no shot, no lollipop).

It should be apparent by now that, to determine whether trust-held assets get a basis step up, it’s necessary to read the trust. The answer to the basis step up question goes beyond the simple inquiry as to whether the trust is revocable or irrevocable. To be sure, assets in a revocable trust will always get a basis step up at the grantor’s death. However, the analysis of irrevocable trusts is more complicated. There are certain types of irrevocable trusts and certain provisions within irrevocable trusts that can cause the trust assets to be included in the grantor’s gross estate, or even in someone else’s gross estate, such as a future trust beneficiary.

No two situations are the same and the question of whether an asset will benefit from basis step up should always be viewed in the context of long-term estate planning. When considering where your assets fall regarding a basis step up, we encourage you to work with your wealth advisor. If you’re a client of Mercer Advisors, our estate planning team works together with your advisor, or we can work with your attorney. Not a client of Mercer Advisors? Let’s talk.

[i] One common exception to this general rule is that income in respect of a decedent (IRD) does not get a step up at the decedent’s death. This is why IRA’s do not get a basis step up at the account owner’s death, because the income attributable to the IRA constitutes IRD.

[ii] The community property states are Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, and Washington. Wisconsin is also generally considered a community property state, although it uses the term “marital property,” which is functionally identical to community property for estate inclusion and basis step up purposes.

[iii] IRC § 1014(b)(6).

[iv] IRC § 2038(a)(1) (“The value of the gross estate shall include the value of all property … [t]o the extent of any interest therein of which the decedent has at any time made a transfer … by trust or otherwise, where the enjoyment thereof was subject at the date of his death to any change through the exercise of a power (in whatever capacity exercisable) by the decedent alone … to alter, amend, revoke, or terminate … .”).

[v] IRC §§ 2031 et. seq.