Step-Up in Basis Rule is an Heir’s Best Friend

The step-up tax adjustment has faced considerable scrutiny over the years, yet it has managed to withstand the numerous challenges it has encountered. This provision, which results in a reduction of capital gains tax for estates, has been a subject of controversy since the 1970s. Despite this, policymakers have continued to express their desire to tap into the substantial tax revenue potential that it offers.

An opposing viewpoint suggests that repealing the step-up basis law could potentially result in significant tax liabilities for assets held across multiple generations. Additionally, the process of sifting through decades-old documentation to reconstruct transactions could prove to be an arduous task. Despite this, the step-up basis issue is likely to remain a contentious topic within estate accounting.

How it works

The narrative commences in the year 1916, coinciding with the adoption of federal estate tax legislation. Prior to this juncture, provisional death taxes had been implemented to garner funds directed toward specific initiatives such as the establishment of the Navy or financing the Civil War. The step-up provision was subsequently introduced in 1921 for all asset categories, encompassing tangible possessions like real estate to intangible investments such as stocks and bonds. Its primary objective was to evade dual taxation on unrealized appreciation after assets had already been taxed once at their fair market value.

The step-up approach is a widely utilized method of valuation that is commonly employed after the demise of an asset holder. Its primary purpose is to reset the cost basis for inherited assets, which represents the original value of the asset adjusted for expenses such as commissions, depreciation, and other relevant costs. The step-up mechanism entails elevating this assessment to be determined as of the date on which the owner passes away, effectively resetting its value. This becomes particularly crucial in cases where an asset has appreciated in value over time, as it serves to exclude any prior gains from taxation when it is sold. Conversely, if the asset has depreciated in value over this time period, the step-up would be rendered immaterial.

Estates have the option to utilize various exceptions in order to minimize tax liabilities. Rather than utilizing the date of death, personal representatives can choose a date six months after the decedent’s passing, if doing so results in a reduced tax bill for the estate. In this scenario, all property must be grouped together for valuation purposes and representatives are not permitted to selectively choose favorable assets. Additionally, it is important to note that the Internal Revenue Service (IRS) closely monitors transactions that are solely designed for tax avoidance purposes. As such, any transfer from an heir to an owner within one year of the owner’s death is not eligible for step-up treatment.

A costly loophole

Numerous administrations have grappled with the challenge of closing a perceived elitist loophole, citing its disproportionate advantages for larger estates. Despite their efforts, repeals advocated by Presidents Clinton, Obama, and Biden have all been unsuccessful thus far.

Setting aside arguments of fairness, the elimination of the step-up in basis on inherited assets would have significant financial implications for government revenues. The Congressional Budget Office predicts that replacing the step-up with the original cost basis would generate approximately $110 billion over a period of 10 years. Similarly, the federal Joint Committee on Taxation estimates that the step-up results in a loss of $42 billion in revenues for 2021 alone.

The step-up provision has had a tumultuous history, being repealed in 1976 and reinstated in 1980, only to be challenged and reversed shortly thereafter due to concerns regarding record-keeping for past transactions. In recent times, opponents of the provision have argued that the apprehension over double taxation is no longer relevant given the small number of individuals currently subject to federal estate tax with the current exemption being over $12 million. Furthermore, critics have claimed that the step-up creates distortions in revenue by promoting a lock-in effect where asset owners avoid selling assets to evade capital gains taxes, thus impeding portfolio choice and liquidity.

Watch out for changing legislation

As a recipient of an inheritance, one can effectively leverage the step-up to mitigate their capital gains expenses within the estate. It is possible that one may not be the initial individual within their family to utilize this strategy. Subsequent beneficiaries, spanning over several years, could continue to transfer ownership of a property while benefiting from the step-up in each generation, thereby incurring minimal capital gains taxes.

It is advisable to stay informed about any potential changes to the tax break in order to remain up-to-date. Homeowners with real estate in high-priced metropolitan areas such as New York City and Los Angeles may have witnessed an increase in property values, making them less vulnerable to any legislative alterations. However, it is important to note that financial portfolios may also be impacted.

It is advisable to seek professional guidance in matters concerning the step-up tax rules. Whether you are receiving an inheritance or planning to leave one, it is crucial to discuss the intricacies with a qualified expert to ensure that all relevant considerations are taken into account.