ARTICLES
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The Step-Up in Basis Rule
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Middle class families bear too much of the tax burden because of unfair loopholes that are only available to the wealthy and big corporations. Discuss with your financial and estate advisors how you hold title to property to ensure that you play by the rules and do not forfeit the step-up rule benefits.
What is the Step-Up in Basis Rule?
In general, when you sell an asset that has risen in value, you pay taxes on the gain. For assets like stocks, the ‘capital gain’ is calculated as the difference between the purchase and sale price. But there is a special rule for inherited property.
Using Alternative Valuation to Maximize the Benefits of the Stepped-Up Basis Loophole
Heirs can opt to take advantage of an alternative valuation date that is no later than six months from the date of death. If an asset has appreciated significantly, this is a fantastic advantage as it allows an even higher cost basis to be enjoyed, lowering future taxes even more.
Common Mistakes
To take advantage of the step-up in basis rule you must avoid certain traps:
If You Give Stock or Property as A Gift While You Are Still Alive, You Will Lose The Stepped-Up Basis Loophole Advantage
Your heirs will not be able to take advantage of the stepped-up basis loophole. Rather, they will inherit your cost basis as if it were their own as if they had been the original purchaser on the same terms, at the same price, and same date that you did. That means it is always a better idea to give cash, or freshly purchased shares (where the market value and cost basis are comparable) instead of keeping the appreciated stock until death.
Traditional 401(k) versus a Roth 401(k)
In a traditional 401(k), employees typically make pre-tax contributions lowering taxable income for the year. With the traditional 401(k) you will still owe income tax on your contributions and investment growth when you withdraw the money in retirement. If you take out any funds before age 59½, you will also owe a 10-percent penalty unless the reason falls under an exemption. Your income tax rate in the year of withdrawal will determine how much you will pay in tax.
In a Roth 401(k), you contribute after-tax dollars to the Roth account within the 401(k) plan. You will not have any tax advantages in the current year, but if wait at least five years from Jan. 1 of the tax year in which the initial contribution was made there will be no future tax due, not even on the earnings component. Like a traditional 401(k), early withdrawals may be subject to income tax and a 10 percent penalty.
For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
What is the Step-Up in Basis Rule?
In general, when you sell an asset that has risen in value, you pay taxes on the gain. For assets like stocks, the ‘capital gain’ is calculated as the difference between the purchase and sale price. But there is a special rule for inherited property.
- Here is how it works - if you inherit specific assets from a deceased relative and later sell it, you are taxed on the difference between what you sold it for, and what the stock was worth when the relative died. Yes, every long-term investor needs to know about the stepped-up basis loophole. This tax benefit for families who are not rich enough to be subject to the estate tax, but who have diligently built wealth by acquiring specific assets (stocks, real estate investments, or other property) throughout their lifetime, and want to pass that money on to their children, grandchildren, nieces, nephews, or other heirs.
Managed correctly, this loophole is a close second to the twin combination of a Roth 401(k), and a Roth IRA in terms of amassing money in the most tax-efficient way within a family tree when you are taking a multi-generational approach.
Using Alternative Valuation to Maximize the Benefits of the Stepped-Up Basis Loophole
Heirs can opt to take advantage of an alternative valuation date that is no later than six months from the date of death. If an asset has appreciated significantly, this is a fantastic advantage as it allows an even higher cost basis to be enjoyed, lowering future taxes even more.
Common Mistakes
To take advantage of the step-up in basis rule you must avoid certain traps:
- Owning your home with your children – if your goal is to avoid probate, and for your children to own real property when you pass, your children should inherit your property through a trust, and not own it in common with you while you are alive.
- Holding title of your home in joint tenancy with your spouse – holding tenancy as joint tenancy, his/her surviving spouse will retain the original cost basis and not get a full double step-up in basis.
- The step-up can also be a step-down if values have dropped at the time of death – you need to be aware of market values of the assets, and any adjustments you plan to make to the ownership/title of those assets.
If You Give Stock or Property as A Gift While You Are Still Alive, You Will Lose The Stepped-Up Basis Loophole Advantage
Your heirs will not be able to take advantage of the stepped-up basis loophole. Rather, they will inherit your cost basis as if it were their own as if they had been the original purchaser on the same terms, at the same price, and same date that you did. That means it is always a better idea to give cash, or freshly purchased shares (where the market value and cost basis are comparable) instead of keeping the appreciated stock until death.
- There is one major exception to this rule - if you are going to go over the estate tax limits, and you do not have a lot of cash on hand, you can use the annual gift tax limit exclusions to give appreciated stock, real estate, or assets to your heirs to lower the size of your estate, saving on the taxes that would otherwise be owed. There are even advanced techniques that have been approved by the tax court involving the use of a Family Limited Partnership to transfer a lot more money thanks to a liquidity discount (do not attempt this without consulting with a qualified tax specialist).
Traditional 401(k) versus a Roth 401(k)
In a traditional 401(k), employees typically make pre-tax contributions lowering taxable income for the year. With the traditional 401(k) you will still owe income tax on your contributions and investment growth when you withdraw the money in retirement. If you take out any funds before age 59½, you will also owe a 10-percent penalty unless the reason falls under an exemption. Your income tax rate in the year of withdrawal will determine how much you will pay in tax.
In a Roth 401(k), you contribute after-tax dollars to the Roth account within the 401(k) plan. You will not have any tax advantages in the current year, but if wait at least five years from Jan. 1 of the tax year in which the initial contribution was made there will be no future tax due, not even on the earnings component. Like a traditional 401(k), early withdrawals may be subject to income tax and a 10 percent penalty.
For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
For current tax or legal advice, please consult with an accountant or an attorney since the information contained in this article is not tax or legal advice and is not a substitute for tax or legal advice.
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RPE Category (Digital Digest)
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REAL ESTATE | REGULATIONS | GOVERNMENT / TAXATION
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PUBLISHED:
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November 09, 2020
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