All About the Stepped-Up Basis Loophole

A stepped-up basis is a tax provision that allows heirs to reduce their capital gains taxes. When someone inherits property and investments, the IRS resets the market value of these assets to their value on the date of the original owner’s death. Then, when the heir sells these assets, capital gains taxes are applied based on this reset value. The result is a situation – often considered a tax loophole – that allows investors to pass assets to their heirs virtually tax-free. If you need help reducing your investment taxes, consider working with a financial advisor.

What Is the Stepped-Up Basis?

The stepped-up basis (sometimes known as the step-up cost basis) is a way of adjusting the capital gains tax. It applies to investment assets passed on in death.

When someone inherits capital assets such as stocks, mutual funds, bonds, real estate and other investment property, the IRS “steps up” the cost basis of those properties. This means that for the purpose of capital gains tax, the IRS sets the original cost basis of any given investment asset to its value when the asset is inherited. When the heir sells this asset, they only pay money on profits calculated from the day they inherited it.

The result of the stepped-up basis loophole is that heirs save significant money on investment assets that they inherit. Moreover, this loophole is crucial for estate planning. When individuals prepare their wills and trusts, they can minimize how much the IRS takes by handing down securities rather than cash.

Example of the Stepped-Up Basis Loophole

Let’s say you own 10,000 shares of ABC Co. stock. You bought those shares at $20, leading to an original cost basis of $200,000. You are planning your will and you want to hand this stock down to your child. At this time, ABC Co. is valued at $30 per share. You likely have two options, outlined below.

Option A: Cash Transfer

For simplicity’s sake, let’s ignore any other tax issues. You sell your shares in ABC Co. Your proceeds are $300,000 and your profits are $100,000. You would pay a standard 15% capital gains tax on this transaction, coming to $15,000. As a result, You pass $285,000 down to your child.

Option B: Stock Transfer

Instead of selling your stock, you hand your shares of ABC Co. down to your child entirely. When you die, ABC Co. is still worth $30 per share. Your child inherits all 10,000 shares and sells them immediately upon receipt.

At the time your child inherits these shares, the IRS resets their original cost basis to $30. Your child sells these shares for $300,000. They owe no taxes on this sale because, as far as the IRS is concerned, he didn’t make a profit off this sale.

The stepped-up basis loophole allows someone to pass down assets without triggering a tax event, which can save estates considerable money. It does, however, come with an element of risk. If the value of this asset declines, the estate might lose more money to the market than the IRS would take. However, keeping that in mind, the stepped-up basis is still an important part of estate tax planning.

How Do Capital Gains Taxes Work?

Capital gains are a special, generally lower, category of taxes imposed at the time a security is sold and based on the amount by which that security has gained value. This is distinct from income taxes, which are imposed on money earned from salary and wages. (Put another way, the income tax is imposed on labor, while the capital gains tax is imposed on investments.) For example, when someone sells stocks, the money that they earn off that sale triggers capital gains taxes.

The capital gains tax applies only to the profits by selling assets. The value of the asset when you first bought or acquired it is called its “original cost basis.” The IRS then calculates your profits by subtracting the proceeds of the sale from the asset’s original cost basis. Capital gains taxes are then applied to those profits.

The agency also taxes short- and long-term capital gains differently. Short-term capital gains, which come from investments sold under one year, are taxed as ordinary income. Conversely, long-term capital gains, which come from investments held over a year, are taxed at a lower rate. The table below breaks down current long-term federal capital gains tax rates:

2024 Federal Long-Term Capital Gains Tax Rates

Example of a Capital Gains Tax Calculation

Let’s say you own 1,000 shares of stock in ABC Inc. When you bought the shares, they were valued at $20 per share, leading to a purchase price, or original cost basis, of $20,000. A few years later, you sell your investment in ABC Co. When you sell the shares, they are worth $35 each. As a result, you now get $35,000 from the sale, which are the proceeds.

You would pay capital gains taxes on your profits from the sale, and your income bracket makes your tax rate 15%. As a result, you may pay the following in taxes:

• Proceeds – Original Cost Basis = Profit
  • Robert’s scenario: $35,000 in proceeds – $20,000 in original cost basis = $15,000 in profits
• Long-Term Capital Gains Rate x Profit = Capital Gains Tax Owed
  • 15% capital gains rate x $15,000 in profit = $2,250 in capital gains taxes

Based on the above, you would owe $2,250 in federal taxes on your sale. This is significantly more preferable than if his capital gains were short-term in nature.

Step-Up Basis in Community Property States

Residents of nine different community property states can take advantage of a double step-up basis tax rule. This allows a step-up basis on all community property for the surviving spouse. Community property means any asset that was accumulated during the marriage with the exception of any gift or inheritance.

In many other states, neither assets that are only owned by the surviving spouse or jointly owned assets do not get the same treatment. The assets of a surviving spouse don’t get any step-up basis and jointly owned assets only get half of the basis. However, a surviving spouse can obtain the step-up basis on anything that is inherited from the deceased in any state.

Bottom Line

A stepped-up basis is a tax law that applies to estate transfers. When someone inherits investment assets, the IRS resets the asset’s original cost basis to its value at the date of the inheritance. The heir then pays capital gains taxes on that basis. The result is a loophole in tax law that reduces or even eliminates capital gains tax on the sale of these inherited assets.

Estate Tax Planning Tips

• A financial advisor can help you establish the right estate plan to minimize potential taxes and help you reach your goals. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
• The stepped-up basis loophole is just one thing to keep in mind when planning an estate. Another key topic is estate taxes. Further, it’s important to understand how estate planning differs from legacy planning.

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