What is Step-Up Basis and How is it Beneficial for Trusts and Estates?
Step-up basis allows for the tax basis to be stepped up to fair market value upon the transfer of an asset at death.
What is basis?
The IRS defines basis as “the amount of your capital investment in property for tax purposes.” Often, the basis is the original cost, or the all-in amount paid for an asset. But that is not always the case. For example, when property is acquired through other means than purchase, such as an inheritance, the basis may be different than the price paid to purchase the asset.
What does step-up basis mean?
A trust or estate’s beneficiaries may benefit from a stepped-up basis to fair market value of the asset(s) they receive. This becomes important when the original tax basis is much lower than the asset’s current fair market value, and the beneficiary sells the asset.
A Simple Example
Jim owns a piece of land in his trust with his son as the beneficiary. The land is currently worth $1,000,000, but Jim purchased it decades ago for just $50,000. This means Jim’s tax basis is $50,000. If Jim were to sell the property now for $1,000,000, he would have reportable income of $950,000 from the sale, thereby creating a tax liability.
If Jim were to pass away without selling the property, the property would be transferred via the trust to his son. What then would be the son’s basis in the inherited property?
The son’s basis would step-up to the fair market value of the property at the time of Jim’s death. So, if the property was worth $1,000,000 when Jim passed away, that would become the son’s basis in the property. If the son then sold the property for $1,000,000, there would be zero taxable gain on the sale.
This illustrates the great advantage of the step-up basis: while the decedent would potentially have a large tax liability on the gain, the stepped-up basis for a beneficiary may greatly reduce the potential tax bill associated with a sale of the asset. A stepped-up basis allows the beneficiary to only pay taxes on gains that were accrued while the asset is in their possession.
The step-up basis can also be advantageous in instances where the decedent owned a depreciable asset, such as an office building. If Jim, from the example above, also owned an office building in his trust, he could depreciate the building during his lifetime. When Jim passes and the building is transferred to his son, the son enjoys the stepped-up basis. There would be no depreciation recapture if the son decided to sell the building. Additionally, if the son holds onto the property, he can begin depreciating it based on the new fair market value.
We hope this helps to illustrate the advantages of the step-up basis. If you have questions about setting up a trust or estate plan, or would like to discuss your current estate plan, RJS LAW has a team of experienced lawyers ready to assist you. Please call us today at (619) 595-1655 or fill out the contact form on the right side of this page. We look forward to assisting you!
Written by Charles Ecker