By: Jessica Lanning JD, CFP® 

The “step-up in basis” rule confounds so many investors and wealth-building families, typically around taxes, how to manage assets, and the financial aspects of estate planning.  Let’s start with the basics and cover why it trips people up.

 

The Basics of Basis

Purchase price is basis … with some adjustments

In its simplest form, “basis” is the acquisition price minus any acquisition expenses.  It could be called cost basis or tax basis.  For this article, we’re going to use the term “basis.”  Understanding basis and knowing what your basis is in any asset is important because it’s used to determine capital gains or losses for income tax reporting when you give it away or sell it.  Typically, you and your tax preparer will establish a basis.  The below will get you started.

 

Where to start:  

You buy a house or a stock or piece of art at a price.  That purchase price is the first piece of data from which you determine the basis.  Sometimes, that’s the only data needed. Bought a house at $300K yesterday?  That’s your basis.  Sell it tomorrow for $500K?  $300K is still your basis.

“An asset’s basis can be modified by what happens at the time of purchase.” 

 

Example: Buying a stock.

Bought XYZ Company stock at $100/share?  That’s at least your starting point for calculating your basis.  Remember, it doesn’t matter at this point whether the value is up or down.  We’re only determining the basis.  The basis is $100.  Often this number is modestly adjusted for acquisition expenses.  For example, let’s say it costs you $2 to execute the trade necessary to acquire that stock.  Then your basis is $98 ($100 – $2).

“Basis can also be modified by what happens after the purchase.  Real estate is the most common example.”

 

Example:  Buying a primary residence.

Bought a house for $300K?  That’s your basis until you make major improvements to the property.  This should be distinguished from maintenance.  Add another 100 square-foot bedrooms for $100K?  That $100K would be added to your $300K basis, and now your basis is $400K.  But if you repaint your house and it costs $15K?  That generally does NOT get added to the basis, even if it does increase the value of the property.

 

Example:  Buying investment property.

Investment property basis has many levers.  Buy an investment property for $300K?  That’s your basis for about a month.  For example, as you take depreciation on the improvements (anything but the land), your basis decreases.  Over years, the basis can go from $300K down to $100K.  Then let’s say you add another 100 square-foot bedrooms for $100K. That would increase the basis to $200K.  Until you start depreciating that addition and the basis start to go down again.

 

Why Basis Is Important

Let’s take a small detour.  Basis matters because when the property is sold, a calculation must be made to determine whether there is a capital gain or loss for tax purposes.  For this article, we’re keeping it simple.

Example:  Buying and selling a stock.

You buy XYZ Company stock for $100 and pay a $2 transaction fee.  Your basis is $98.  You sell it for $200 with a $2 transaction cost.  You receive $198 in proceeds.  Your capital gain on that transaction is $100 ($198 – $98).  You may have capital gains taxes to pay on that gain.  How much is taxed and at what rate we’ll save for another article?

 

Example: Buying and selling a primary residence.

You buy a house for $300K.  You add a $100K addition.  You paint it for $15K.  Your basis is $400K ($300K + $100K, as the $15K won’t count toward basis).  You sell for $350K.  You have a loss of $50K ($400K – $350K).  What happens to this loss is dependent on your tax situation.  If you sell for $900K, you have a gain of $500K ($900K – $400K).  Again, what capital gains taxes you owe we’ll save for another time.

 

Example:  Buying and selling investment property.

You buy an investment property for $300K.  You put on a $100K addition.  Your basis is $400K.  You depreciate that property over 25 years.  Your basis is now, let’s say, $100K.  You sell it for $900K.  Your capital gain is $800K ($900K – $100K).  Again, what capital gains taxes you owe we’ll save for another article.

 

That little detour is important because what happens when you receive a gift of property or receive an inheritance of property impacts the taxes owed, depending on the basis.  

 

What about the gifted property?

Gifts.  

For this article, a gift is when someone while alive gives someone else a piece of property.  If you receive a gift of property from someone who is still alive, you take on the basis of the person giving the gift at the time of the gift, even if that person dies the next day.  

 

Example:  Neighbor gifts stock to a friend.

Neighbor buys XYZ Company stock at $100 with a $2 transaction fee.  The basis is $98.  Three years later neighbor gives it to a friend when the value is $200.  The friend sells the stock at $200 with a $2 transaction fee.  The friend receives $198.  He has a capital gain of $100 ($198-$98) on which he may have to pay capital gains taxes. 

 

Example:  Mom gifts real estate to son.

Mom buys a house for $300K.  She adds on a $100K addition.  Her basis is now $400K.  Several years later, the house is worth $900K.  She gives it to her son.  The son’s basis in the house is $400K.  If he sells it tomorrow at $900K, he’s got a $500K gain on which he will likely pay taxes.

 

What About Inherited Property? 

The Step-Up in Basis Rule.

Inheritance.  

For this article, inheritance is when someone receives property after someone else dies through a probate or trust administration process.  Colloquially, we’ll say things like “I got this house as a gift from my grandma when she died.”  But that’s not a gift.  That’s an inheritance.   This distinction is important because the tax implications can be wildly different.

 

Step-up in basis.  

As of the writing of this article, the “step-up in basis” rule still exists until Congress changes it.  What this means is that when someone receives property as an inheritance, that person gets a step-up in basis to the value of the property at the date of death.  In other words, the inheritor gets a NEW basis rather than the basis of the person who died.

 

Example:  Neighbor bequeaths stock to a friend.

Neighbor buys XYZ Company stock at $100 with a $2 transaction fee.  The basis is $98.  Three years later the neighbor dies, bequeathing the stock to the friend when the value is $200.  The friend now has a basis of $200.  The friend sells the stock at $200 with a $2 transaction fee and receives $198.  The friend actually has a small loss of $2 ($198 – $200) and likely no taxes to pay.

 

Example:  Mom gifts real estate to son.

Mom buys a house for $300K.  She adds on a $100K addition.  Her basis is now $400K.  Many years later, she dies, bequeathing the son the house, now worth $900K.  The son’s basis in the house is $900K.  If he sells it tomorrow for $900K, he a gain $0 ($900K – $900K), and no taxes to pay.

 

What This Means for Planning

People often look at these examples above between gifting and bequeathing and immediately conclude that no highly appreciated asset should ever be gifted during one’s lifetime and that all assets should be bequeathed at death.  But that choice is not always so obvious or the most strategic.

  • Sometimes gifting an asset to someone in a lower tax bracket make sense because that person would pay less in taxes.
  • If someone’s heirs are facing a huge tax bill when that someone dies, gifting assets to others to remove those assets from someone’s estate can reduce the estate tax bill.  For instance, gifting highly appreciated assets to non-profits that don’t pay taxes is often better than giving the non-profit money because the non-profit can sell the asset, have a gain, but pay no taxes.  
  • In another instance, gifting an asset that one expects to appreciate highly (like real estate) to others during one’s lifetime can distribute the tax burden as well.  
  • And in more complicated planning, people with taxable estates can employ strategies like a charitable remainder trust or a Deferred Sales Trust to allow others to earn income and potentially eliminate or defer the capital gains tax owed until way in the future.  

Congress threatens to eliminate the step-up in basis rule frequently, but so far it has remained protected.  I advise anyone with total assets over a million dollars to pay attention to these rules and what legislation is moving through Congress, as the estate tax exemption changes frequently and the step-up in basis rules seemingly always has its head on the chopping block. Planning for distribution requires some forethought about your desires for the property and managing your transfer costs and taxes.  But first?  Figure out your basis.

 

About the Author:Stepping Up and Stepping Out – Understanding the Step-Up in Basis Rule

Jessica Lanning JD, CFP® brings focus and perspective to your individual financial needs to identify your opportunities for investment and wealth. Regardless of what you’ve done before or what “mistakes” you think you’ve made, Jessica can help get you back on track quickly and safely. As a former practicing lawyer, she brings a comprehensive approach to legal, tax, and financial challenges so that her clients can enjoy peace of mind. A huge proponent of conscious decision-making, Jessica makes sure her clients are educated and informed so that they make sound decisions with clarity and confidence. 

 

Lanning Financial Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.

 

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