Step-Up in Basis – What You Need to Know – The White Coat Investor – Investing & Personal Finance for Doctors

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The step-up in basis at death is a critical financial concept for you to understand. It affects investing, estate planning, asset protection, and especially tax decisions you make throughout your life. If you aren’t aware of it, you may overpay your taxes by tens or even hundreds of thousands.

How the Step-Up in Basis Works

The basic law works like this:

Tax basis is what the IRS considers you to have paid for an asset. When you sell an asset that has appreciated, you owe capital gains taxes on the difference between the basis and the value on the date you sell it. When someone dies and leaves an asset to an heir, the tax basis resets to the value on the day of death. That could be bad if the asset has fallen in value between the date it was purchased and the date of death (because a taxable loss was not booked) but generally, it is a good thing, reducing capital gains taxes for the heirs.

Here is a typical example:

Joe Sr. uses $10,000 to buy 1000 shares of stock for $10 a share in 1972. He keels over in 2020. Those shares are now worth $100 a share, for a total of $100,000. He left the shares in his will to his only son Joe Jr. Joe Jr. is an index fund investor and doesn’t want to own this individual stock. But he really doesn’t want to pay capital gains taxes on $90,000 in gains. Luckily for him, he gets a “step-up in basis” and can sell the shares the day he inherits them for $100,000 and pay NOTHING in capital gains taxes. In fact, if the value of the shares fell to $97,000 over the course of the next year, he could sell them at a loss and use that $3,000 loss against his ordinary income like any other tax loss harvesting scenario. It is just like he bought them on the day he inherited them.

The 6 Month Rule

But wait! This gets even better. You don’t even have to use the date of death if you don’t want. Within one year after death, the executor can designate an “alternate valuation date” up to six months after death.

So let’s say someone dies in the midst of a big bull market. By the time everything is sorted out months later, you realize that the property (stocks, income property, or a home) has appreciated 30% since the date of death. Now you’re going to owe capital gains taxes on that 30% gain when you sell. So instead you have the executor designate an “alternate valuation date” of six months after death. Now that date is used to set your basis.

Of course, when you do this, it must apply to ALL of the assets in the estate. You can’t pick a different date for each stock, mutual fund, property, and automobile. It’s entirely possible that the rise in value with one asset will cancel out a drop in another. Use IRS Form 706 to set an alternate valuation date.

Aside from increasing basis, this alternate date may also help an estate close to the estate tax exemption limit stay under that limit (if assets have fallen in value).

Gifts Do Not Get a Step-up in Basis

One technique that people sometimes use to reduce capital gains taxes is to gift assets from one person in a high bracket to a person in a low bracket. You can give an unlimited amount to anyone in any given year, but if you give more than $15,000 you must file a gift tax return (Form 709) and the amount over $15,000 is subtracted from your estate tax exemption limit–$11.58M in 2020 ($23.16M married). But when you give a gift, the giver passes along the basis to the recipient. That’s great while you’re living and the recipient is in a much lower bracket. But paying no capital gains taxes is even better than paying less in capital gains taxes.

 

7 Ways People Screw Up the Step Up in Basis

 

Let’s see if we can think of all the ways people screw up from not understanding the step-up in basis.

# 1 Death Bed Gifts

Perhaps the worst possible thing you can do is take an asset with very low basis compared to its value and give it away on your death bed. In the case of our $10 per share stock example above, you just saddled the recipient with a tax bill on a $90K capital gain he wouldn’t have had in a few days.

# 2 Living on the Wrong Assets

Now consider an elderly person who needs to take some money from her portfolio. She has a choice between selling an asset with high cost basis and one with low cost basis. She figures, “I’ll sell the one with the low cost basis and pay the taxes myself because my heir will be in a higher bracket than mine.” Wrong move. She should have sold the asset with the high basis since the basis on the inheritance will be reset.

# 3 Selling Assets Instead of Borrowing Against Them

Grandpa needs some spending cash to pay for his nursing home. He can sell his expensive house, pay the capital gains due, and use the proceeds to pay for the nursing home. Or he can keep it, put a renter in it, and take out a mortgage on it. The renter covers the mortgage and the cash from the mortgage pays for the nursing home. Which is the right move? Well, you have to run the numbers (and guess how long he’ll live), but chances are good that his heirs will receive more money if they inherit the house instead of the cash left over after paying taxes and the nursing home. The closer you are to death and the lower your basis, the better off you are paying interest instead of taxes.

# 4 Rejiggering a Portfolio

As we learn more about investing, we often realize our prior investments were not the wisest. We wish to get rid of them because we want the best possible investments and we hate being reminded of our mistakes.

This is no big deal in a tax-protected account like a 401(k) or Roth IRA. No capital gains taxes must be paid when selling an investment there. But in a taxable account, it can be costly to swap investments.

When you have many years of investing ahead of you and the basis of your investments is very close to their value (or you have a lot of tax losses saved up), it’s probably worth selling a crummy investment to buy a new one. When you’re 90, that’s probably not the case. The crummy investment is unlikely to be worse than the capital gains taxes paid to swap.

Even at a younger age, if the older investment is almost as good as the newer one, you probably shouldn’t change. Consider an S&P 500 Index Fund charging 15 basis points a year versus a Total Market Fund charging 5 basis points a year. Yes, it’s better, but it’s not THAT much better.

One benefit of regularly giving to charity is you can give appreciated shares instead of cash and “flush” capital gains out of your account. This can allow you to rejigger your portfolio without paying capital gains taxes.

# 5 Leaving an IRA to an Heir Instead of a Taxable Account

Here’s another way people screw up the step-up in basis. Let’s say you want to leave some money to your heir. Soon after you die, they’re going to use that money to buy a house. You’re also going to give some money to charity. You have a $500K IRA and a $500K taxable account. Which one do you leave to the charity and which one to the heir? Well, if you leave the IRA to the heir, they’re going to pay taxes on the entire withdrawal. It’s basically all pre-tax money. Yes, they could stretch it for up to 10 years first, but that’s not going to overcome the difference. If instead, you leave the IRA to the charity, nobody pays taxes on that money and the heir gets the step-up in basis with the taxable account.

# 6 Buying Whole Life Insurance In Order to Leave a Tax-Free Inheritance

Lots of people get suckered into buying buy a whole life insurance policy so they can leave tax-free money to their heirs. It is true that the death benefit of any life insurance policy (term, whole life, variable life, whatever) is income tax-free to the heir. However, so is just about everything else you leave the heir. It is treated exactly the same as leaving them a rental property or a mutual fund portfolio. And it’s worse than leaving them a Roth IRA (since that can be stretched another 10 years with no required RMDs.)

The real downside of a long-term “investment” in a whole life policy is its low returns. If you invest $250K in a mutual fund portfolio that makes 8% over 50 years or $250K in a whole life policy that makes 5% over 50 years, the heir will receive $11.7M instead of $2.9M. Obviously, that’s not the case if you die early (where insurance provides more money to the heirs), but someone who dies near, at, or beyond their life expectancy is highly likely to leave more money tax-free with traditional risky investments like stocks and real estate.

Whole life insurance should generally only be used when there is a need for a guaranteed death benefit and certainly not just because you “want to leave a tax-free inheritance.”

# 7 Shared Assets

Some parents think it would be really helpful and facilitate estate planning to put their heir’s name on the title of their home. That way, when they die the property is easily transferred to the heir. Bad idea. The heir no longer gets that step up in basis. Same problem with a joint investment account or rental property. It’s probably fine to do this with a bank account or a depreciating asset like an automobile (although there are some obvious asset protection concerns there), but don’t do it on anything that is increasing in value.

The step-up in basis is an important financial principle to understand to avoid expensive screw-ups. There are some political proposals to eliminate it, but in my opinion, they are unlikely to pass. One of the best features of the step-up in basis is that you don’t have to go back for decades to figure out what the basis was. If it were eliminated, a lot of people could be hosed because Grandma didn’t keep any records. Audits on this topic would be terrible. The step-up eliminates all of that hassle.

What do you think? Good law? Bad law? Are there any other screw-ups that people who don’t understand the step-up in basis make? Comment below!