Navigating the Step-Up Tax Basis Rule

I occasionally have discussions with people receiving inherited IRAs who think they can escape both income and estate taxation because of the step-up in tax basis rule. You may have heard of the step-up in tax basis, but what is it?

If you receive property outright from someone on the account of their death, then your tax basis in the property generally is the value of that property on such date of death. For example, your dad died and left you his house that he bought in 1965 for $10,000. The property was worth $80,000 on his date of death. That is your step-up tax basis. You then sold the house after your dad’s death for $80,000. When you sold the house for $80,000, the $70,000 gain escaped all capital gain and other income taxation forever. Great result.

An alternate valuation date can be used in certain circumstances. You can elect to use the value on the date six months from the date of death if both the value of the gross estate and the estate tax liability is reduced.

If instead of transferring the property after your dad died, he gifted the property to you during his lifetime by deed into your sole name, there would be a different result. Your tax basis in the property would then be $10,000. This is called the carryover basis rule. When the property sold for $80,000 after your dad’s death, you would then have capital gains income taxes on that $70,000 capital gain. Bad result.

There is a special rule for gifted property you sell for a loss. Your basis is the lesser of the carryover basis or the fair market value on the date of gift. This prevents your mom or dad from transferring the loss to you.

These basis rules apply to just about any assets that are not held in an income tax-advantaged financial vehicle such as a retirement plan or IRA. These types of financial vehicles have pre-tax dollars in them that never have been subject to income tax. Because of this, the step-up in tax basis rule does not apply to these financial vehicles after a death. In addition, because there was no lifetime transfer, the carryover basis rule also does not apply.

When you withdraw funds out of these income tax-advantaged vehicles after your mom or dad’s death, they are taxed to you as ordinary income, just as they would have been taxed to mom or dad if they had drawn them out during their lifetime.

Another situation in which the tax basis rules confuse many is joint ownership. If your mom or dad added you as a joint owner of their property, there is a different income tax treatment to you, depending upon whether the property is sold before or after they die.

If that joint property is sold during mom or dad’s lifetime, you would have to pay capital gains income taxes on the property using your share of mom or dad’s carryover basis. There is no step-up in basis for these types of gifts when they are sold during the original owner’s lifetime.

On the other hand, if the joint property was not sold until after your mom or dad’s death, you can receive a full step-up in basis of that property to the value on your mom or dad’s date of death. If your mom or dad was the original buyer of the property, you contributed nothing to the purchase, and they retained an interest in the property at the time of their death, you would get that full step-up in tax basis after your mom or dad died. You would only pay capital gain income taxes on the increase in value after their date of death. Another great result.

To minimize the income tax burden, your parents should not take their name off their property and their property should not be sold until after their death, however, you might want to pay some income taxes in order to reduce the estate tax liability.

The step-up in basis rule is a little different with joint ownership between a husband and a wife. It does not matter which spouse contributed to the purchase of the property. For property held jointly by a husband and wife, each spouse is deemed to own one-half of the property. Upon the death of one spouse, the surviving spouse gets a step-up in basis in the half received from the deceased spouse and a carryover basis in their own half.

Some people think the step-up in tax basis causes life insurance to be income tax-free to the beneficiaries when paid after death of the insured. While it is true the proceeds of most life insurance policies are income tax free to the beneficiaries, it has nothing to do with the step-up in tax basis. It is just a tax code provision. Although these proceeds are income tax free, they are not always estate tax free.

The tax basis rules have nothing to do with whether an asset is included in mom or dad’s taxable estate for federal estate tax purposes. The full date of death value of mom or dad’s assets are generally part of their taxable estate, including retirement plans, IRAs, joint property and life insurance proceeds. If mom or dad’s taxable estate is above the IRS exemption amount of $3.5 million in 2009, unlimited in 2010 or $1 million in 2011 and thereafter, all of the amounts in excess of that IRS exemption amount are subject to federal estate tax which is about 50%. Bad result.

Because there is no federal estate tax if mom or dad died in 2010, there are special basis rules for just one year. If mom or dad died in 2010, your tax basis in property received from mom or dad would be the lesser of carryover basis or the fair market value on the date of death. In certain circumstances, limited step-up in basis is still available.

Do not try this at home alone. Consult with your tax adviser to determine the best course of action regarding your entire tax liability. You need to determine if it is better to pay income taxes to save estate taxes or not. Your estate may not even have an estate tax liability.