Key points:
- What is step-up in basis? A tax provision that resets the cost basis of an inherited asset to its fair market value at the time of the owner’s death.
- The method of receiving property—whether as a lifetime gift or an inheritance—drastically changes the tax outcome.
- The type of trust used to hold property determines if a step-up in basis is applicable.
Navigating the complexities of inherited property requires a clear understanding of tax laws to ensure a smooth transition of wealth between generations.
Jennifer V. Abelaj, J.D., CPA, an award-winning tax attorney specialized in Trusts and Estates, answered a few questions to help us navigate the tax laws around inherited property basis.
Q: What is step-up in basis?
Jennifer: In order to understand how the step-up in basis works and why it’s so powerful, you’ll want to know how cost basis is determined.
The cost basis is important because it dictates the amount of capital gains that are subject to tax when inherited property is later sold.
The two most common ways cost basis is determined are –
- initial purchase price or
- date of death value (step-up in basis).
Initial Purchase Price
An owner’s initial purchase price follows that asset until it is either sold or the owner dies. After the property is sold, the new purchaser’s cost basis is the price they paid for the property.
The Little CPA Note: Let’s say you bought a an investment property for $500,000. For you, $500,000 with any qualified adjustments (i.e., home improvements) becomes your cost-basis in the home.
Three years after purchase, you sell the home for $700,000. As a result, your capital gain is $200,000 ($700,000 less your cost-basis.)
The new owner’s cost basis is $700,000.
It is important to note that the property must be sold for consideration (i.e., for value) and at arms-length in order for a bona fide sale to occur.
The Little CPA Note: An arms-length transaction occurs when two unrelated parties agree to a price that serves their own best interest. For instance, if a mother sells her house to her daughter for a price below market, that transaction might not be considered “arms-length” because the price serves the daughter’s interests more than the mother’s.
Sold Property vs Gifted Property
A gift that is made for no consideration (i.e., for no value) is not a sale for purposes of changing the cost basis of the property.
For instance, if an owner gifts property during their lifetime, such as to a child for zero dollars, the owner’s initial purchase price remains with the property and transferred to the recipient. This means that if the child later sells the property, the child’s cost basis is the parent’s initial cost basis, and not the basis at the time of the transfer.
Date of Death Value
When an individual dies, the assets that the decedent (the person who has passed) owns are automatically given a new cost basis. That basis is based on the value of the asset at the decedent’s date of death.
Assets generally increase in value over time. As a result, the value of the asset at the decedent’s death is higher than when the decedent initially purchased it.
The beneficiary receives the asset with the higher basis that is “stepped-up” to the decedent’s date of death value. The property can also be “stepped-down”, but this is unusual.
By receiving the same property with a higher stepped-up basis, the beneficiary’s capital gains will be determined on the date of death value and not on the initial owner’s purchase price.
Q: Does the property have to be held in a trust in order for the beneficiaries to receive the step-up in basis?
Jennifer: No.
To better understand how the trust structure impacts the step-up in basis, it is important to know that there are broadly two types of trusts: revocable and irrevocable.
Revocable Trust
Revocable trusts are created by a Grantor (the person who establishes the trust) during their lifetime. The trust provides instructions to the Trustee (the person legally entitled to administer the trust) to hold assets for the benefit of certain persons.
A Grantor maintains full control over the terms of the revocable trust and has the power to amend, alter, revoke or terminate all or any part of the revocable trust. By maintaining broad control, the Grantor is deemed to “own” the assets held in the Trust during life and at the Grantor’s later death.
Any assets held in a revocable trust receive a step-up in basis as if the assets were owned by the Grantor in her individual name.
The Little CPA: Not all assets are subject to the step-up in basis. Real estate, building equipment, stocks, bonds, ETFs and artwork are examples of property eligible for a step-up in basis. IRAs, assets in other retirement accounts, Money Market accounts and Certificates of Deposits are examples of assets that are not eligible for the step-up in basis.
Irrevocable Trust
Irrevocable Trusts generally require that the Grantor release all of her ability or power to make any changes or receive any benefits from the trust during her lifetime.
A transfer of assets to an irrevocable trust is considered a gift for estate and gift tax purposes.
The trust receives each gifted asset with the tax basis as it was determined while owned by the Grantor.
The Irrevocable Trust is the owner of the assets it holds and the Grantor’s later death does not impact the basis of the trust’s assets.
(There are some exceptions for advanced estate and gift tax planning, but this is keeping it simple.)
Conclusion
Inheriting property can be a complex process, especially when it comes to the tax implications.
Generally, assets transferred at death receive a step-up in basis. Assets transferred by gift do not receive a step-up in basis.
If you are in charge of settling an estate or handling the inheritance of property, it is important to understand how the step-up basis works and how trust structure can impact the basis of inherited assets.
About the Expert
Jennifer V. Abelaj is founder of the Jennifer V. Abelaj Law Firm, located in New York City. Her practice emphasizes all aspects of Trusts and Estates, Not-for-Profits, and relevant Taxation.
Jennifer helps clients plan and carry out goals for estate tax planning and trust administration. She implements sophisticated tax structures to maximize the wealth that individuals pass on to their heirs or charitable beneficiaries. Jennifer represents executors, fiduciaries, and trustees in administering estates with the Surrogate’s Court or communicating with the IRS on estate, gift or trust tax audits.
Jennifer was named as Rising Leader of the Private Client Global Elite Directory for 2022-2023. Jennifer a director of The Nonprofit Cooperative and Chair of the Trust and Estates Section of the Metropolitan Black Bar Association. She conducts regular seminars and workshops on trust administration, business succession planning, and creation of not-for-profits. She has been quoted for expertise in taxation in: The New York Times; Bloomberg; Tax Notes; Law360.
Prior to practicing law, Jennifer was a Certified Public Accountant.
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