Step-up in basis is an IRS tax rule used to adjust an inherited asset’s value to conform to its fair market value for tax purposes upon the decedent’s death. The step-up in basis rule reduces the capital gains tax burden on the inherited property.
The value of the property immediately before a decedent’s death is treated as an income for tax basis reporting, subject to certain exemptions proportionate to its fair market value. Generally, a property’s value is higher at the date of a taxpayer’s death than it was when originally acquired. A step-up in basis is applied to transferred assets to eliminate the heir’s taxable capital gain liability.
A step-up in basis refers to the process of adjusting the value of inherited property to equal its fair value market value to reduce the transfer tax burden.
The step-up in basis rule is applicable to inherited assets at the time of the decedent’s death.
Economists have frequently called for the replacement of the step-up in basis in favor of lower capital gain taxes, as it would encourage recognition of capital gains and increase federal tax revenues.
Understanding Step-Up in Basis
The income tax system in the U.S. is founded on the basic precept that all wealth accretion is subject to tax. This concept is extended to the realization principle that allows deferment of income realized from properties until a point in which there is a disposition.
When a property is inherited, the difference between an inherited asset’s adjusted basis and the amount realized gives a capital gain or a loss that must be taxed or deducted. Thus, a step-up in rule reflects the accrued capital gains or depreciation recapture of an inherited asset.
For example, an heir who inherits shares trading at $12 when their original owner purchased them at $4 creates a step-up in basis. This makes the cost of shares equal to the current fair market value of $12, eliminating the gain accumulated during the investor’s holding period. Furthermore, the $12 becomes the cost basis for any future disposition, not the original purchase price of $4.
Step-Up in Basis for Inherited Properties
The step-up in basis rule adjusts the tax burden for inherited properties compared to other forms of properties. Under a step-up in basis, the value of an inherited property at the time of inheritance is the basis value used to calculate the capital gain tax when the heir sells the property, rather than its original purchase price. It implies that the heir does not bear the capital gain tax accumulated due to appreciation before the decedent’s death.
Using the same example, assume that a mother bought a home property for $30,000 and later dies when its market value was $250,000, leaving it to her son. Should the son decide to sell the home at $250,000, the property would receive a step-up in basis of $250,000, meaning there would be no capital gain. Similarly, if the mother placed the home on a revocable trust and retained the right to the income for the rest of her life, then her son will be eligible for a step-up on the basis.
Changes in Step-Up in Basis for Inherited Properties
The principle of step-up in basis no longer applies to properties inherited after December 2009 under the current IRS laws. A modified carryover basis is applicable to the above case, rather than the step-up in basis rule. Therefore, the inherited asset basis is equivalent to the lower of its fair market value as of the date of the decedent’s demise.
In such a case, suppose an asset’s tax basis is higher than its fair market value as of the decedent’s death. The heir receives the lower fair market value because the basis is stepped-down. The new criterion is not unlimited, and it allows step-up in basis under two basic conditions. One of the conditions is that the step-up in basis only applies to the aggregate amount of appreciation is not less than $1.3 million, plus $3 million of asset appreciation given to the heir.
Criticisms Over Step-Up in Basis
The step-up in basis rule deviates from fundamental tax principles, and as a result, drawing criticisms as a tax loophole for super-rich individuals. Such individuals are said to evade or reduce capital gains tax liability by placing their assets in estate trusts.
For example, an ultra-rich investor might invest in assets anticipated to accrete and accumulate significant wealth before death. The heir will enjoy the fruits of step-up in basis after the decedent’s death. The tax burden that amounts to millions of dollars will be waived.
Another cause for its grudging acceptance is the challenge of identifying the original asset tax base accurately because of poor record-keeping. The call for the repeal of step-up in basis recommends as a replacement the adoption of lower capital gain taxes that still obey the death rule.
Based on the said concept, all unrealized losses and gains would be realized and be filed in the final tax return following the taxpayer’s death. Supporters of the concept argue that its twin virtue can improve the tax system’s administration, not to mention bridging the gap between economic inequality.
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