Step-Up in BasisSome methods of avoiding probate can cost your heirs tens of thousands of dollars if you don’t take into account the tax savings available through using the step-up in basis.

Step-up in basis is tax terminology that many people know about, but don’t understand in the context of estate planning, gifting, and family wealth planning. The basis is the original price at which an asset is purchased. It is the starting point for figuring your profit or loss when you sell the asset. Anything above the basis is profit, and anything below the basis is loss. Of course, the IRS assesses a tax on the profit. The profit could qualify for capital gains or not, depending upon lots of factors.

There are two basic principles in family wealth planning that need to be understood about basis. First, if you receive any gift over the annual tax exclusion, the guy who gives you the gift has to pay a gift tax. The tax is calculated on the fair market value of the gift when it is given. You don’t have to pay any income tax or any kind of other tax when you get the gift. The dirty secret the IRS keeps from you is that you have to use the donor’s original basis when you go to sell the asset you got as a gift.

The second concept is that you get a step-up in basis on any property you inherit. The property that passes through your dad’s estate is taxed at the value it has on the day your dad dies. This is the estate tax. The federal government has an estate tax and about 16 states have state estate taxes. Note that if the asset you receive gets a step-up in basis because it comes to you through inheritance, then if you sell the asset for what it was worth the day your dad died, you won’t have any income tax issues. You wouldn’t show a profit or loss, because you sold the asset at its basis.

So with a gift, you have to use the original basis, but on inherited property, you get to use the step-up basis. That all seems simple, right? The problem comes in how you get the property. Most of the probate avoidance tricks people perform to avoid probate result in a gift transaction, even though nobody intended a gift to be given. For those using joint tenancy or a “dresser drawer deed” for probate-avoidance, they only think they are inheriting the property. If Dad puts your name on a deed as a joint tenant, he is giving you half the property. Gift tax issues come into play and no step-up in basis is available for the half of the property you now own. If he does a dresser drawer deed or gives you the property outright, he is giving you a gift. Your gift has to take the original basis in all of these cases, and any increase in value from that basis when you finally sell the property is taxed to you as capital gains.

Most of the cases of houses handed down through tricks like joint tenancy or deeds are very costly because the children often end up unnecessarily paying thousands or tens of thousands of dollars in taxes when the property is sold. This is a shame because if the family had only understood what they were doing, there wouldn’t have been any estate tax payable and the asset would have gotten a step-up in basis. The “unified credit” will make it so most families don’t have to pay estate taxes, even though the tax is assessed. Check out my my video above for a more complete story on step-up in basis concepts, gifting, unified credit, and related topics.

2 Comments
  1. Dear Mr. Phillips:

    I purchased your course on how to form a Living Revocable Trust and prepare a Will in 2012. I placed my primary home into the Trust, but now I am 76 years old and would like to sell my home within the next 15 months. The real estate taxes on my home in New Jersey are the highest in the country. I am looking for a condo in a retirement community to purchase or rent also in New Jersey, since my children live nearby. I can reduce my real estate taxes that I pay for my 1/3 acre 4 bedroom development home by about $6,000. If I purchase the condo, should my Trust purchase the condo? Can I use the cost of the condo to reduce the tax on my profit from the sale of my home? Thank you, Ben

  2. Benjamin,
    You are going to want to buy the condo in the name of your trust. If you are getting a mortgage on the condo you will need to buy it in your personal name but can quit claim it to the trust soon after the purchase. If the home you are selling is a personal residence then you will already get a tax break on the income from the property. You get $250,000 exemption on the income if you are filing single and $500,000 exemption if you are filing jointly.

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