How the Step-Up Basis Works

Last month, we covered how to calculate an asset’s tax basis, which plays a major role in an individual’s ongoing financial responsibilities and taxes. The long-term tax implications that derive from the tax basis of an asset can have a major impact on future planning for yourself and, in the case of business assets, your business.

Cost basis is the cost to acquire a particular, and is the initial tax basis of an asset. A tax basis, however, can change over time. One such instance is referred to as the step-up basis. Calculating the step-up basis comes when an asset is transferred at the time of death or through an estate.

What the step-up basis does is it prevents those who inherit assets from being held responsible for the tax basis and decisions of the previous owner. In general, this would apply to situations where a parent or parents leave assets to their children after the parents pass away.

For instance, if you bought real estate for $500,000 but the value of the property doubles over time to a current value of $1 million, your kids would inherit the asset at $1 million. They do not owe any capital gains on this asset because the value is stepped up to $1 million instead of the previous basis of $500,000.

Now, if you were to sell the home after inheriting it at a higher price, then you will be responsible for the capital gains on the difference between the sale price and the stepped-up tax basis. This adds an often unnecessary additional cost to you which becomes even more apparent if you depreciate the asset.

Say you were to purchase a $400,000 property that you depreciate to $0 over time. You started with a tax basis of $400,000 but then lowered it to $0 through the depreciation deduction. If you sell the property, you will be responsible for a capital gains tax on every dollar above $0. So, if the property is now worth and sold for $800,000, you will owe a capital gains tax on that $800,000. However, if you leave the property as an inheritance then transfer the property to your heirs upon your passing, they will inherit the asset at a value of the current fair market value. Instead of paying a capital gains tax, you never realize those gains and your heirs start at the date-of-death value as opposed to the value you depreciated the asset to.

This showcases precisely why it’s imperative to have proper legal and tax planning in place before you make significant purchases, sales, or gifts in your lifetime. This holds true for individuals and businesses alike who hold high-value assets. Our team of professionals can protect you from unwanted taxes and expenses when managing your assets. Contact the Law Offices of Tyler Q. Dahl and make sure you’re getting the most out of tax and legal strategy.

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