Thanks to a generous federal gift and estate tax exemption amount ($13.61 million for 2024), only the wealthiest of families are exposed to estate tax liability. For many, this means that estate planning now has a stronger focus on income tax planning. And one of the most valuable tax planning areas is the “stepped-up basis” rules.
Capital gains rules
Normally, when assets such as securities are sold, any resulting gain is a taxable capital gain. If the assets have been owned for longer than one year, the gain is taxed at favorable rates. The maximum tax rate on a long-term capital gain is 15% but increases to 20% for certain high-income individuals.
Conversely, a short-term capital gain is taxed at ordinary income tax rates, as high as 37%. Gains and losses are accounted for when filing a tax return, so high-taxed gains may be offset wholly or partially by losses.
The amount of a taxable gain is equal to the difference between the basis of the asset and the sale price. For example, if you acquire stock for $10,000 and then sell it for $50,000, your taxable capital gain is $40,000.
These basic rules apply to capital assets owned by an individual and sold during his or her lifetime. But a different set of rules apply to inherited assets.
Stepped-up basis rules
When assets are passed to the younger generation through inheritance, there are no income tax implications until the assets are sold. For these purposes, the basis for calculating gain is “stepped up” to the value of the assets on the date of death. Thus, only the appreciation in value since the individual inherited the assets is subject to tax. The appreciation during the deceased’s lifetime goes untaxed.
Assets affected by the stepped-up basis rules include securities, artwork, bank accounts, business interests, investment accounts, real estate and personal property. However, these rules don’t apply to retirement assets such as 401(k) plans or IRAs.
To illustrate the benefits, let’s look at a simplified example. Alan bought XYZ Corp. stock 10 years ago for $100,000. In his will, he leaves all the XYZ stock to his daughter, Barbara. When Alan dies, the stock is worth $500,000. Barbara’s basis is stepped up to $500,000.
When Barbara sells the stock two years later, it’s worth $700,000. Thus, she must pay a maximum 20% rate on her long-term capital gain. On these facts, Barbara has a $200,000 gain. With the 20% capital gains rate, she owes $40,000. Without the stepped-up basis, her tax on the $600,000 gain would be $120,000.
What happens if an asset declines in value after the deceased acquired it? The adjusted basis of the individual who inherits the assets is still the value on the date of death. This could result in a taxable gain on a subsequent sale if the value rebounds after death or a loss if the value continues to decline.
Take caution when using a grantor trust
An intentionally defective grantor trust (IDGT) is a popular estate planning tool that allows you to remove assets from your estate for estate tax purposes while continuing to be treated as their owner for income tax purposes. As a type of irrevocable trust, an IDGT allows you to shield all future appreciation in the assets’ value from estate tax, while continuing to pay the trust’s income taxes, further reducing the size of your taxable estate.
Some experts have argued that because assets gifted to an IDGT remain taxable to the grantor for income tax purposes, they’re entitled to a stepped-up basis in the hands of beneficiaries. However, in Revenue Ruling 2023-2, the IRS clarified that assets in an IDGT aren’t received by bequest, devise or inheritance and, therefore, aren’t eligible for a stepped-up basis.
An uncertain future?
The stepped-up basis rules can be complex. And it’s worth noting that in 2021, the Biden administration tried, but failed, to eliminate what it called the “stepped-up basis loophole” for single taxpayers with capital gains greater than $5 million. If President Biden wins reelection in 2024, the rule may again be in question. Turn to your estate planning advisor to answer your stepped-up basis rules questions.
SIDEBAR: Tax angles of making lifetime gifts
One way to reduce estate tax liability is to make lifetime gifts to family members. Under the annual gift tax exclusion, you can give each recipient gifts valued up to $18,000 in 2024 without any gift tax ($36,000 per recipient for joint gifts by a married couple).
However, a carryover basis rules regime applies to lifetime gifts. If you give appreciated property to a family member, their basis for income tax purposes is your initial cost. For example, Charlotte bought XYZ stock for $10,000 and gives it to her son Daniel when it’s worth $15,000. Daniel sells it for $16,000, so he owes tax on a gain of $6,000.
Conversely, if gifted property is sold at a loss, the basis is the lesser of the carried over basis or the value on the date of the gift.