Stepped Up Cost Basis

Question:  I’ve inherited investments from my parents and am told there will be an adjustment or step up in the cost basis information. What does this mean for me? 

Answer: I’m sorry for the loss of your parents, please accept my condolences. It sounds like your parents implemented proper estate planning that is a crucial tax consideration. Sometimes overlooked, cost basis adjustments can be a taxation game changer. 

Under this tax provision, your cost basis for tax purposes is determined not from the original owner’s purchase price but from the value when inherited after death. Since most assets appreciate over time, this adjustment is called a “step up” in basis. This can mean significant savings in taxes when an asset is sold, often allowing beneficiaries to maximize their inheritance.

Generally, assets included in the decedent's gross estate will receive an adjustment in basis. For example, stocks, land, and business interests are all eligible for an adjustment in basis. However, some Income in Respect of the Decedent (IRD) assets, such as IRAs, 401(k)s, and annuities, aren’t eligible.

How step-up works

Under current tax law, the cost basis is the asset’s value on the date of the original owner’s death. Depending upon how long an heir holds the asset before selling and other factors affecting its valuation, the asset may technically accrue little to no gain – and you as the heir may face little to no capital gains tax on it.

Taxes being taxes, things can never be quite that simple. Some assets may decrease in value over time, leading to the application of a step-down basis. Furthermore, jointly owned assets between spouses may have different rules for basis adjustments when one of the spouses passes away. These different rules depend on the couple’s state of residence and whether it’s a community property or common law state.

What’s the scenario?

For estate planning purposes, the first step in determining where the step-up basis may be helpful while outlining estate planning goals. As you adjust and update your estate planning there are questions you may want to consider as well. Are you philanthropic? Do you want to leave your vacation home to your daughter and your stocks to your grandchildren? Do you have an estate plan but think it might need review through the lens of the step-up basis?

Let’s take one common scenario to illustrate how the step-up can benefit your heirs: Ten years ago, you bought 20,000 shares of a company’s stock for $20 a share, so the original cost basis is $400,000. Now those shares are worth $40 each, or $800,000, and you’d like your adult children to receive that stock.

Depending on your intent, you have several options to pass along that asset to your children. You could sell the shares, assume the tax liability, and gift your children cash. You could also directly transfer the shares, and they'd receive the same basis in your stock ($20 per share). Or you could name your children as beneficiaries of those shares. As long as those shares are in a taxable account and included in your gross estate when you pass away, they’ll get an adjustment in basis based on the fair market value on your date of death. If the fair market value of the shares is $50 per share at your passing, your children will receive a step up in basis to $50. The gain of $30 per share, or $600,000 gain will pass to your children free of any tax liability!

The step-up tax basis can be a valuable tool in estate and tax planning. Consult with tax professionals, your estate planning team, and your financial advisor to find out which assets are eligible for an adjustment in basis and to identify the appropriate beneficiaries for each asset based on your estate planning goals. Stay focused and plan accordingly. 

Raymond James does not provide tax advice. Please discuss these matters with your tax professional.

Changes in tax laws or regulations may occur at any time and could substantially impact your situation. Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professionals.

Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. The opinions expressed are those of the writer as of November 24, 2023, but not necessarily those of Raymond James & Associates, and subject to change at any time based on market conditions and other factors. There is no guarantee that these statements, opinions, or forecasts provided herein will prove to be correct. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. allocation. 

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