Step Up in Basis at Death

When we die, our assets are valued at the market value at the date of our death or an alternate valuation date, six months later. That's the value that is used to compute any estate taxes that might be due. That's also the value that is used by a beneficiary who sells inherited property.

For example, father has some XYZ stock that was inherited from grandfather who paid $15 a share for the stock, after adjusting for any stock splits or stock dividends. Assume the value of the stock when grandfather died was $65 per share.  When father got the stock from grandfather’s estate, father’s cost for tax purposes would have been $65 per share. The $50 per share of gain while the stock was owned by grandfather is not subject to income tax -- even if there was no taxable estate. If father sells the stock for $100 per share, father will owe taxes on only $35 per share. If father keeps the stock until he dies and he leaves it to his children when it’s worth $150 a share, his children will have a tax cost of $150 a share for that stock when they sell it.

But - the value of stock is included in father’s estate and it may be subject to federal estate taxes of up 50%. Thus, it isn’t that the gain is never taxed. It’s a question of whether it’s taxed as a capital gain at a currently maximum rate of 15% for long term capital gains or whether it’s subject to the estate tax at rates ranging from zero to 50%. 

A simple rule of thumb is that when the taxpayer’s estate is below the $1,500,000 threshold at which the estate tax begins to apply, then there is a definite benefit to the family in holding any appreciated assets unless it's necessary to sell them for non-tax reasons. To the extent that the estate is reduced down to the point where there are no estate taxes, the appreciated property will pass to the next generation with a higher tax cost - which is referred to by tax professionals as a "step up in basis".  Property that passes at death is valued based on the fair market value at the date of death (or an alternative date six months later). That value is then used to determine if an estate tax is payable.  Regardless of whether an estate tax is due, that value is also used to measure the amount of any future gain or loss when the property is sold by the heir of the taxpayer who receives the property. 

Generally, property jointly owned by a married couple is treated as being half owned by each spouse. If some stock that cost $10 per share were worth $100 a share when you died, your half of the shares would be re-valued at $100 per share and your spouses' half would retain the original cost of $10 per share. 
 
When there is a need to choose between an estate tax of up to 50% of the value of the property and a capital gains tax of up to 15% of the gain on the property, it’s often better to make annual exempt gifts of low cost (basis) assets to avoid the estate tax even though the property may later be subject to capital gains taxes. 

Generally, any deferred income taxes on assets left at death are subject to tax by the estate or by a designated beneficiary of the deferred income. Examples include tax deferred retirement savings plans, individual retirement accounts and tax deferred annuities.

Citation: Internal Revenue Code Section 1014

Copyright, 2003, Vernon K. Jacobs

Vernon Jacobs is the Editor/Publisher of The International Wealth Protection Reports, which are a collection of research reports on legal methods of asset protection and tax avoidance. Further information on this subject is available at http://www.offshorepress.com/  Jacobs is a CPA who has worked as a free lance tax and financial author/editor since 1977. Details about his credentials and experience are online at http://www.offshorepress.com/vkjcpa/  

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