Friday, September 26, 2014

The Basics of the "Stepped-up Basis" -- a Big Loophole to Avoid Tax on Investment Gains

Even if you are not a close follower of estate planning issues, it is worth learning the basics of the most famous tax loophole in the Internal Revenue Code, known as the automatic step-up in basis at death.

After you learn the basics of the rule, remember this:  Before deciding to sell any stocks, bonds, real estate, or other investment property, always consider the consequences the sale could have on your family's ability to use this loophole.  You don't need to know all the ins and outs of the rule; simply seeking legal advice if you identify a potential "step-up" issue could save your family tens or hundreds of thousands of dollars.


Paula, a widow, has one adult daughter. 

In 2011, Paula bought 2,000 shares of Apple stock for $100,000. 

Today, Paula's 2,000 shares of Apple stock are worth $200,000. 

Paula has lived a long and happy life, but she has a serious medical condition and her doctors say she now has less than a year left to live.  She wants to give $200,000 from the Apple stock to her daughter.   Our goal is to get as much of that money to her daughter as possible.

Let's look at the tax implications of two options:

1) Paula sells the stock now and gives the proceeds to her daughter, or

2) Paula holds on to the stock and passes it to her daughter at death.

Option 1 (Pay Lots of Taxes):

If Paula sells her stock today, the federal government will tax her on the gain (or appreciation) in her Apple stock.  Calculating this gain is a simple subtraction problem.  Take the value of the stock on the date of the sale ($200,000), and subtract the "basis", which is the value of the stock on the day it was purchased ($100,000).  $200,000 sale price minus $100,000 basis equals a $100,000 gain. 

For simplicity, let's say in Paula's tax bracket, she owes 15% federal capital gains tax on that $100,000 gain.  15% of $100,000 is $15,000 in federal tax.  If her state tax rate is 5%, she will owe an additional $5,000 in taxes on the sale, for a total of $20,000 in taxes. 

Option 2 (Take Advantage of the "Step-Up" Loophole)

Let's say instead of selling the Apple stock during her life, Paula keeps the stock until her death.  She then passes it on to her daughter through a will, living trust, or by naming her as a death beneficiary on her investment account.  For simplicity, let's say the stock is worth $200,000 on the date of Paula's death.  Paula's daughter takes possession of the stock, and then decides to sell it right away.

The stock is worth $200,000 today but was purchased for $100,000, so using the subtraction problem from above, Paula's daughter will still owe taxes on $100,000 in gain...right?  Wrong!

Under the Internal Revenue Code Section 1014(a), when someone receives property upon another's death, the "basis" value of the property is calculated at the date of death, not the day the investment was purchased.  So, the IRS forgets about the fact that the property was actually purchased by Paula for $100,000, and the new basis is "stepped up" to $200,000. 

The subtraction problem becomes $200,000 sale price minus $200,000 "stepped-up basis", which equals zero taxable gain.  15% federal tax on $0 is $0.  5% state tax on $0 is $0.  Paula's daughter takes the property and owes no income tax.

Option 2 saves Paula's family $20,000 in tax, money that could have been lost had she not know about the "step up" loophole!


One of the fundamental principles of tax is that income (gain) is subject to taxation.  The Section 1014 "step up" is a huge exception to these rules.  But it is easy to miss out on the benefit if you aren't paying attention.  Remember, this is just a brief overview and is not individual legal advice, so make sure to consult an estate planning professional if you have property that might qualify for this loophole.

Published by the Law Office of Ian Holzhauer in Naperville, IL.  

Note:  The information above is not legal advice and is not the basis of an attorney-client relationship.  If you need assistance, you can hire an attorney to assist you with your individual legal needs.