The step up in basis at death is a critical financial concept for you to understand. It affects investing, estate planning, asset protection, and especially tax decisions you make throughout your life. If you aren't aware of it, you may overpay your taxes by tens or even hundreds of thousands.
How the Step Up in Basis Works
Tax basis is what the IRS considers you to have paid for an asset. When you sell an asset that has appreciated, you owe capital gains taxes on the difference between the basis and the value on the date you sell it. When someone dies and leaves an asset to an heir, the tax basis resets to the value on the day of death. That could be bad if the asset has fallen in value between the date it was purchased and the date of death (because a taxable loss was not booked) but generally, it is a good thing, reducing capital gains taxes for the heirs.
Here is a typical example:
Joe Sr. uses $10,000 to buy 1000 shares of stock for $10 a share in 1972. He keels over in 2020. Those shares are now worth $100 a share, for a total of $100,000. He left the shares in his will to his only son Joe Jr. Joe Jr. is an index fund investor and doesn't want to own this individual stock. But he really doesn't want to pay capital gains taxes on $90,000 in gains. Luckily for him, he gets a “step up in basis” and can sell the shares the day he inherits them for $100,000 and pay NOTHING in capital gains taxes. In fact, if the value of the shares fell to $97,000 over the course of the next year, he could sell them at a loss and use that $3,000 loss against his ordinary income like any other tax loss harvesting scenario. It is just like he bought them on the day he inherited them.
The 6 Month Rule
But wait! This gets even better. You don't even have to use the date of death if you don't want (and your estate is large to owe estate taxes). Within one year after death, the executor can designate an “alternate valuation date” up to six months after death.
So let's say someone dies in the midst of a big bull market. By the time everything is sorted out months later, you realize that the property (stocks, income property, or a home) has appreciated 30% since the date of death. Now you're going to owe capital gains taxes on that 30% gain when you sell. So instead you have the executor designate an “alternate valuation date” of six months after death. Now that date is used to set your basis.
Of course, when you do this, it must apply to ALL of the assets in the estate. You can't pick a different date for each stock, mutual fund, property, and automobile. It's entirely possible that the rise in value with one asset will cancel out a drop in another. Use IRS Form 706 to set an alternate valuation date.
Gifts Do Not Get a Step Up in Basis
One technique that people sometimes use to reduce capital gains taxes is to gift assets from one person in a high bracket to a person in a low bracket. You can give an unlimited amount to anyone in any given year, but if you give more than $15,000 you must file a gift tax return (Form 709) and the amount over $15,000 is subtracted from your estate tax exemption limit–$11.58M in 2020 ($23.16M married). But when you give a gift, the giver passes along the basis to the recipient. That's great while you're living and the recipient is in a much lower bracket. But paying no capital gains taxes is even better than paying less in capital gains taxes.
7 Ways People Screw Up the Step Up in Basis
Let's see if we can think of all the ways people screw up from not understanding the step up in basis.
# 1 Death Bed Gifts
Perhaps the worst possible thing you can do is take an asset with very low basis compared to its value and give it away on your death bed. In the case of our $10 per share stock example above, you just saddled the recipient with a tax bill on a $90K capital gain he wouldn't have had in a few days.
# 2 Living on the Wrong Assets
Now consider an elderly person who needs to take some money from her portfolio. She has a choice between selling an asset with high cost basis and one with low cost basis. She figures, “I'll sell the one with the low cost basis and pay the taxes myself because my heir will be in a higher bracket than mine.” Wrong move. She should have sold the asset with the high basis since the basis on the inheritance will be reset.
# 3 Selling Assets Instead of Borrowing Against Them
Grandpa needs some spending cash to pay for his nursing home. He can sell his expensive house, pay the capital gains due, and use the proceeds to pay for the nursing home. Or he can keep it, put a renter in it, and take out a mortgage on it. The renter covers the mortgage and the cash from the mortgage pays for the nursing home. Which is the right move? Well, you have to run the numbers (and guess how long he'll live), but chances are good that his heirs will receive more money if they inherit the house instead of the cash left over after paying taxes and the nursing home. The closer you are to death and the lower your basis, the better off you are paying interest instead of taxes.
# 4 Rejiggering a Portfolio
As we learn more about investing, we often realize our prior investments were not the wisest. We wish to get rid of them because we want the best possible investments and we hate being reminded of our mistakes.
This is no big deal in a tax-protected account like a 401(k) or Roth IRA. No capital gains taxes must be paid when selling an investment there. But in a taxable account, it can be costly to swap investments.
When you have many years of investing ahead of you and the basis of your investments is very close to their value (or you have a lot of tax losses saved up), it's probably worth selling a crummy investment to buy a new one. When you're 90, that's probably not the case. The crummy investment is unlikely to be worse than the capital gains taxes paid to swap.
Even at a younger age, if the older investment is almost as good as the newer one, you probably shouldn't change. Consider an S&P 500 Index Fund charging 15 basis points a year versus a Total Market Fund charging 5 basis points a year. Yes, it's better, but it's not THAT much better.
One benefit of regularly giving to charity is you can give appreciated shares instead of cash and “flush” capital gains out of your account. This can allow you to rejigger your portfolio without paying capital gains taxes.
# 5 Leaving an IRA to an Heir Instead of a Taxable Account
Here's another way people screw up the step up in basis. Let's say you want to leave some money to your heir. Soon after you die, they're going to use that money to buy a house. You're also going to give some money to charity. You have a $500K IRA and a $500K taxable account. Which one do you leave to the charity and which one to the heir? Well, if you leave the IRA to the heir, they're going to pay taxes on the entire withdrawal. It's basically all pre-tax money. Yes, they could stretch it for up to 10 years first, but that's not going to overcome the difference. If instead, you leave the IRA to the charity, nobody pays taxes on that money and the heir gets the step up in basis with the taxable account.
# 6 Buying Whole Life Insurance In Order to Leave a Tax-Free Inheritance
Lots of people get suckered into buying buy a whole life insurance policy so they can leave tax-free money to their heirs. It is true that the death benefit of any life insurance policy (term, whole life, variable life, whatever) is income tax-free to the heir. However, so is just about everything else you leave the heir. It is treated exactly the same as leaving them a rental property or a mutual fund portfolio. And it's worse than leaving them a Roth IRA (since that can be stretched another 10 years with no required RMDs.)
The real downside of a long-term “investment” in a whole life policy is its low returns. If you invest $250K in a mutual fund portfolio that makes 8% over 50 years or $250K in a whole life policy that makes 5% over 50 years, the heir will receive $11.7M instead of $2.9M. Obviously, that's not the case if you die early (where insurance provides more money to the heirs), but someone who dies near, at, or beyond their life expectancy is highly likely to leave more money tax-free with traditional risky investments like stocks and real estate.
Whole life insurance should generally only be used when there is a need for a guaranteed death benefit and certainly not just because you “want to leave a tax-free inheritance.”
# 7 Shared Assets
Some parents think it would be really helpful and facilitate estate planning to put their heir's name on the title of their home. That way, when they die the property is easily transferred to the heir. Bad idea. The heir no longer gets that step up in basis. Same problem with a joint investment account or rental property. It's probably fine to do this with a bank account or a depreciating asset like an automobile (although there are some obvious asset protection concerns there), but don't do it on anything that is increasing in value.
[Update: Apparently, if you have a joint tenancy, that does not necessarily mean you lose the step up in basis. More details here.]
The step up in basis is an important financial principle to understand to avoid expensive screw-ups. There are some political proposals to eliminate it, but in my opinion, they are unlikely to pass. One of the best features of the step up in basis is that you don't have to go back for decades to figure out what the basis was. If it were eliminated, a lot of people could be hosed because Grandma didn't keep any records. Audits on this topic would be terrible. The step up eliminates all of that hassle.
What do you think? Good law? Bad law? Are there any other screw-ups that people who don't understand the step up in basis make? Comment below!
The 6 month rule is hard to use. You can only have an alternate valuation date if it lowers the estate tax (which will usually be zero).
(c) Election must decrease gross estate and estate taxNo election may be made under this section with respect to an estate unless such election will decrease—
(1) the value of the gross estate, and
(2) the sum of the tax imposed by this chapter and the tax imposed by chapter 13 with respect to property includible in the decedent’s gross estate (reduced by credits allowable against such taxes).
reference https://www.law.cornell.edu/uscode/text/26/2032
Keep in mind the Democrats and Joe Biden really want to get rid of the set up in basis. They will probably keep at it until they eventually take it away.
The government continues to get bigger and bigger and needs more money to fund it. So for those of us probably below age 60 I seriously doubt this will be around when we die.
I don’t see it passing due to it being such bad policy. There are better, easier, simpler ways to raise taxes than that.
Concerning the transfer of a home to get a step-up in basis:
1. Assume the proposed home beneficiary is a child living with and caring for an elderly parent, without other home ownership of their own. If the beneficiary is placed on the deed as a co-owner, and the parent dies. what happens? I assume that without any other prior legal arrangements, the new owner’s basis is zero and the full market price becomes the capital gain. The question is whether the capital gain occurs on death, or on the sale of the house (which may not occur for decades). Furthermore, does the one time capital gain exemption on home sales still apply?
2. For states that offer a “Transfer on Death Deed” (like Utah and Oregon), I believe that the step-up basis in the home is captured for the new owners (beneficiaries) with the benefit of minimal legal hassle. This may be an option for those considering an “outside of probate” disposition of their home on their death.
1. On the sale of the house, but you inherit the cost basis of the parent. I guess the exemption would still apply though.
2. That’s a good question, but I think you’re right, the step up occurs.
This article got me thinking….is there a blog post on WCI or a good resource for best things to organize/discuss to prepare for the death of a sole aging parent (should the will be reviewed before the death, should child’s names be taken off joint bank accounts, need parent’s SSA login credentials, what to discuss with siblings, etc)? Also, what are the things to do right after the death of a parent (appraisal of the house inherited, etc)?
That would be a good post. If you or someone you know has recently become an expert, here’s how to submit a guest post:
https://www.whitecoatinvestor.com/contact/guest-post-policy/
Thanks to WCI, Bogleheads, PoF and others I am well on my way to financial independence and I am only three years removed from fellowship. This has also allowed me to help my parents out after bankruptcy a few years ago. I recently cosigned with them on a mortgage for a home for which they paid the down payment and I help cover the mortgage payments. Currently my name is on the deed and mortgage. My parents plan to pass the house on to me and my brother when they pass. Since my name is on it already, I have considered trying to get my name off the mortgage/deed so that I can avoid paying any capital gains taxes on the house when my brother and I sell it after they die.
So my question is twofold:
– should I speak with a real estate attorney about getting my name off the property now ?
– does anyone know if my name has to be off the deed or mortgage or both to avoid capital gains?
Thanks for the great article!
Yes.
Not sure, but I would think the deed. Obviously there is risk to taking it off the deed (i.e. it could be given to someone else).
Good estate planners will keep this rule in mind and while planning with you, carefully evaluate your plans for your assets in terms of maximizing step up in basis. This can include transferring some assets into the name of the spouse who is more likely to pass away first (I know it’s not pleasant to think about, but can make a very large difference in taxes owed). Also, I’m not sure the 6 month rule works for income tax basis, only the value of the asset for estate tax purposes; that’s a question I’d have to double check via research if it ended up changing a client’s plans. Anyone already know that one?
Also, Violet, you are definitely thinking along the right lines. A full review of a person’s estate plan is important at least every 10 years, or when something significant has changed in the person’s life. All the points you raise are important, and what actions should be taken depends on the person; each estate plan varies to fit each person’s life. After death, family or friends should check in with an estate planning and probate attorney to see what needs to be done.
That’s a good strategy. Thanks for sharing. Some families might want it in the name of the younger/healthier spouse and others might want it in the name of the older/sicker spouse.
I’m not sure on the income tax basis specifically, I figured it would be one and the same.
Is there a difference in the step-up basis if the heir is added to the deed vs the creation of a life estate, with the child as the remainderman?
I think a life estate is a remainder trust, no? So I think the trust gets a step-up when the property is transferred into it.
What about listing on deed transfer on death for real estate and payable on death for other accounts this is allowed for? These allow for immediate transfer to heir upon showing death certificate. But do they allow for step up in basis?
Yes, immediate transfer and a step up in basis. It’s a great option to avoid probate when available.
Hi WCI,
I am a bit confused about how the step up basis plays with a spouse. I’m assuming that in a community property state, the step up basis goes in effect when both spouses die and the kids or trust inherits, whereas in a non community property state, after the death of one spouse the surviving spouse gets the step up basis.
Thanks.
Via email:
Dr. Dahle, love all your great WCI work. I read with interest the recent post on stepped-up tax basis. On joint tenancies (parent puts child on the house deed), at death (but not before death), the adult child does get a step-up in basis on both halves (I blogged about it today here: https://fitaxguy.com/transferring-a-primary-residence-to-children/). I included an analysis of the tax rules to help establish that the adult child does get the step-up in both halves here (https://fitaxguy.com/wp-content/uploads/2020/08/Basis-of-Inherited-Property-NCNSJT.pdf). It is an area over which there is a whole lot of confusion among practitioners (and for many reasons, joint tenancies are not generally advisable).
My mom can’t afford a home on her own but I want her to move closer to me. Was thinking I title the house to her but be a co-signer on the loan (which I’ll be paying). After she passes, do I still get the step-up or does this hit a gray area?
You should get the step-up if you do not own the house. Interesting scheme. The typical recommendation in this situation would be for you to just own the house and certainly never co-sign for the house. But if your mom doesn’t screw you over, I can see where there would be some tax savings via the step-up in basis. Just be aware she could leave the house to someone else…
So my spouse and I have an investment account title Joint Tenants With Rights of Survivorship: I have been told that when one of us dies, the other will receive a “half” step-up for cost basis of the account. Is there a way to get a “full” step-up and not just a “half” step-up? Do we need to re-title the account? If so, how should it be titled. We both have Wills and we live in WA State, community property.
Thanks !
Gene:
Because you’re in a community property state, you can get a full step in basis on the first spouse’s death if property is community property.
However, having the account as “Joint Tenants With Rights of Survivorship” could mean under the law (to know for certain, this might take some research), that it’s not community property. This all gets a bit technical, and practically speaking, you want to get to the right answer in the quickest and most sure way possible. You can first look into seeing how easy it is to have the account titled as a community property or “Husband and Wife.” If yes, and if it truly is community property (again, technically speaking, just titling it a certain way doesn’t necessarily mean it truly is and there’s no possible way to challenge that designation), then just name each spouse as the designated beneficiary and you know for certain you’re good. Also, for what it’s worth, it’s not very likely the IRS will ever look very hard at this. It’s more likely an angry ex-spouse will, but hopefully that’s never going to be a concern either. You also may want to look into preparing a community property agreement to possibly make the account CP if the property in it isn’t already CP (although you don’t want a CPA saying one thing and the account title saying something very different). Use CPAs with caution though, they can mess up other planning. This is all general information, I’d need more facts to give specific advice for your situation.
I live in a non-community property state and my wife & I use a typical revocable living trust for probate avoidance. The revocable trust is a “joint” trust with both of us serving as co-trustees and our daughter the successor trustee when the first of us dies or incapable of serving. Assets are to be distributed by our daughter upon the last of us to die. All of the assets transferred to the trust were jointly owned beforehand. Our plan is for significant asset appreciation so as to allow our daughter (only child) to receive the step up in basis and avoid a large capital gains tax problem. (Retirement plan accounts are, of course, ineligible for this treatment, and simply put, they are what they are.) While we currently do not have an estate tax issue, we might in 2026 when the exclusion reverts to a lower amount. The portability rule helps greatly. Our main issue now is capital gain taxes to our daughter. I understand that when the first of us dies, since the trust is a joint trust (and equivalent to jointly owned assets outside a trust), that 1/2 of these trust assets will receive a step up in basis. If continued to be held by the surviving spouse, upon his/her death, the second 1/2 of the assets will receive a step up in basis at that time. But will the first 1/2 of assets that has already received a step up in basis now get a 2nd step up? There are no contribution issues as we are husband and wife, and over our lives these assets received essentially 50-50 contributions. Or, should the “joint” trust be separated into two singularly owned trusts by each spouse owning 1/2 of the total assets? Thanks.
I don’t think so. Just one step up for each half I believe, but I’m not 100% sure. This seems to support that view (scroll to the end):
https://www.czepigalaw.com/files/all_you_need_to_know.pdf
But will the first 1/2 of assets that has already received a step up in basis now get a 2nd step up?
I am not a lawyer. I believe it is possible to write a trust so that the survivor receives the inheritance either in trust or outright. In this case the inheritance is not protected from creditors or estate tax on death of the survivor. In this case the basis steps up on all assets on death of the survivor.
It is also possible to write a trust so that the survivor inherits a trust that escapes estate tax on the survivor’s death (a bypass trust). This would also have some creditor protection. In this case there is no step up on the assets inherited by the survivor of the first death.
What does your trust do? If you want to revoke it or amend it you may.
I agree with Dr. Dahle; you can’t get a second step-up in basis. While some people can get a second step-up in basis, mainly only in community property states, you won’t. I have to disclaim that we’d have to have a full consult and I’d perhaps have to research this to know for certain, but it’s very unlikely. If a surviving spouse holds assets outright, including what’s inherited from the first spouse, those do get a full basis step up at that time. That’s one way to get a second step-up, but not always advisable. That’s another reason for a full consult; we have to coordinate planning for all assets and balance multiple factors. Trust planning often differs from state to state because of state law; it can be hard to compare due to varying net worths, personal preferences, family situations, etc.
I am all for saving money and not paying a financial advisor but if you do this please actually know the rules. You are way off with the Alternate Value for estates. This may only be used if estate tax is due! For the 99% of estates under the current exemption this cannot be used. Please correct this error. Thank you.
Thanks for the correction.
My parents owned several stocks in an account as joint tenants with rights of survivorship. When my father died, his name was removed from the account and I was added as joint tenant with my mother. My mother passed away several years ago and I am the sole owner of the account. I’m thinking of selling or donating some of the stocks. How do I calculate cost basis?
Thank you.
Oops. That was an expensive mistake.
You’ll need to find some old records. I’d contact the custodian of the account (Vanguard, Fidelity?) and see if you can get it. Otherwise, I think your assumed basis is $0 and you’ll owe capital gains even on what was originally principal.
I am not a CPA and the following response may or may not be accurate:
I think the basis of any stock in the portfolio is what the original purchase price was.
When you were gifted your position on the account, you did not qualify for a step up in basis.
Now, instead of you being placed on the account when your father passed away, your mother kept the account in her name only with you as the beneficiary, when she passed away, you would have inherited the portfolio with a full step up in basis, that is, your basis price for the stocks would be their price on the date of your Mom’s death.
Having said the above, if some or all of stocks were purchased prior to tax year 2011, look into what the meaning of “covered” and “not covered” means as you examine your options for determining basis.
My wife and I live in a community property state (California). In addition to and separate from my Rollover IRAs, we have substantial stock holdings in our family living trust.
It is my understanding that upon the death of one of us, the other has the right to sell all of our stock in the family trust immediately with no capital gains tax, because the tax basis of all the stock steps up to its current value at time of death. Thus, there is no capital gain to tax.
If two days after doing this I bought all the same stock back, wouldn’t I still have that higher tax basis? And then if I sold that stock two months later, assuming the market has not gone up during that short time period, I would again owe virtually no taxes because of the stepped up stock basis.
Is my analysis correct?
I believe that is correct. Cool trick eh?
https://www.cpajournal.com/2017/08/18/greatest-hits-community-property-step-basis/