All About the Stepped-Up Basis Loophole

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

Once again, Robert owns 10,000 shares of ABC Co. stock. He bought those shares at $20, leading to an original cost basis of $200,000. Robert is planning his will and he wants to hand this stock down to his son. At this time, ABC Co. is valued at $30 per share. Robert has two options.

Option A: Cash Transfer

For simplicity’s sake, let’s ignore any other tax issues.

Robert sells his shares in ABC Co. His proceeds are $300,000 and his profits are $100,000. He pays a standard 15% capital gains tax on this transaction, coming to $15,000. As a result, Robert passes $285,000 down to his son.

Option B: Stock Transfer

Instead of selling his stock, Robert hands his shares of ABC Co. down to his son entirely. When Robert dies, ABC Co. is still worth $30 per share. His son inherits all 10,000 shares and sells them immediately upon receipt.

At the moment Robert’s son inherits these shares, the IRS resets their original cost basis to $30. Robert’s son sells these shares for $300,000. He owes 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 is 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, 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:

2023 Federal Long-Term Capital Gains Tax Rates

Note that President Joe Biden proposed raising taxes for long-term gains over $1 million. This means that high-income investors over that amount would be taxed as ordinary income and pay a top rate of 39.6%.

Example of a Capital Gains Tax Calculation

Robert owns 1,000 shares of stock in ABC Inc. When he 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, Robert sells his investment in ABC Co. When he sells the shares, they are worth $35 each. As a result, Robert gets $35,000 from his sale, which are the proceeds.

Robert pays capital gains taxes on his profits from the sale, and his income bracket makes his tax rate 15%. As a result he pays 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, Robert owes $2,250 in federal taxes on his 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 have the ability to 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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