Understanding The Step-Up Rule On Inherited Assets

One of the ways that Congress collects taxes from citizens is by taxing investments. You pay a tax when you sell a stock at a gain, for instance, which is the capital gains tax.

Likewise, income from stock dividends are taxed. While the rates have varied over the years, generally these tax rates are lower than the top income tax rate, so many rich people try to avoid normal income and instead try to live on their investments.

Where things get tricky is when an asset, such as a stock or a home, is inherited. Under current law, the inheritor gets to make a one-time tax move that essentially wipes out what can be a significant tax bill.

Here’s a simplified example: Let’s say a parent owns a stock they bought years ago at $10 a share. It has increased in value and current trades at $100 a share.

If the parent sells the stock, he or she will owe the capital gains tax on the $90 gain. There are a couple of different capital gains rates but let’s assume for this example it’s 15%.

So the parent owes 15% of $90 in taxes, or $13.50.

Now let’s say the parent decides not to sell and just holds the stock until death. It trades at $100 on the day the parent passes away.

Now the child inherits the stock and decides to sell that day. What is the capital gain tax? Zero.

That’s because inheritors get to “step up” the cost basis, wiping away what the parent paid for the stock and adjusting the basis to current market value.

The child can now reinvest or save or spend or whatever they like. The new cost basis is $100. He or she will owe capital gains taxes only if the shares appreciate even more in the future and then they choose to sell. 

Even then, it will be only then on the difference between the later price and new basis, $100.

Appreciated real estate, too

This same logic applies to homes, which have appreciated greatly over the past few years. If your parents bought a home for $100,000 and left it to you with a market value of $500,000, you could sell it and pay no tax on the $400,00 difference. All the IRS asks is that you report the sale.

It’s possible that Congress will change the step-up rule and there has been some talk in Washington about limiting its usefulness to high income earners or even eliminating the rule outright.

While such a move could raise revenue it also would be politically difficult in any environment. Incoming administrations often float the idea of killing the step-up but few in Congress get behind such policies.

That’s not to say it will never happen but that the terms will likely be complex and carefully negotiated so as to minimize the number of people affected by such a change.

It’s nevertheless a good idea to stay apprised of potential policy changes and adjust your own retirement planning assumptions accordingly.  This article is not tax advice.  Please contact your tax professional before making any investment decisions.

MarketRiders, 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.