Understanding the Step-Up in Basis Rule: A Key Strategy for Estate Planning

In recent years, the approach to estate planning has evolved significantly. Historically, much of estate planning focused on moving assets out of your estate to minimize exposure to estate taxes. However, with the current high estate tax exclusion amounts, there's now a shift towards keeping assets within the estate to take full advantage of the step-up in basis rule. As of 2024, the federal estate tax exclusion amount is $13.61 million for individuals and $27.22 million for married couples. This means that most estates will not be subject to federal estate tax, allowing planners to focus on strategies that reduce capital gains taxes for heirs. One such strategy involves maximizing the benefits of the step-up in basis rule, which can offer significant tax savings to heirs upon the death of the asset owner.

What is the Step-Up in Basis Rule?

When an individual passes away, the assets they leave behind, such as stocks, real estate, or other appreciated investments, often increase in value over time. The step-up in basis rule allows the heirs to inherit these assets with a “stepped-up” tax basis, which is the fair market value of the assets on the date of the decedent’s death.

This stepped-up basis is advantageous because it resets the original purchase price of the asset for tax purposes, potentially minimizing capital gains taxes when the asset is eventually sold by the heirs.

Community Property States vs. Separate Property States

The step-up in basis rule operates differently depending on whether you live in a community property state or a separate property state.

Community Property States

In community property states, married couples jointly own most assets acquired during the marriage. When one spouse passes away, both halves of the community property are eligible for a step-up in basis. This means that the surviving spouse receives a full step-up in basis on the entire property, not just the deceased spouse’s half. This can significantly reduce or eliminate capital gains taxes if the property is sold shortly after the spouse’s death.

States that are community property states include California, Texas, Arizona, Idaho, Louisiana, Nevada, New Mexico, Washington, and Wisconsin.

Separate Property States

In separate property states, each spouse owns their assets individually unless they are held in joint accounts. When one spouse dies, only the deceased spouse’s share of the asset receives a step-up in basis. The surviving spouse’s half retains its original cost basis.

For example, if a married couple in a separate property state owns an appreciated asset jointly, and one spouse dies, the surviving spouse only benefits from the step-up in basis on the decedent's half of the property. The other half, still held by the surviving spouse, retains its original basis.

Strategic Asset Transition: Capitalizing on the Step-Up in Basis

In separate property states, careful estate planning can help maximize the benefits of the step-up in basis. One effective strategy involves transitioning appreciated assets from a joint account to an individual account held by the spouse who is closer to passing away.

How Does This Work?

If the spouse with a shorter life expectancy holds appreciated assets in their name alone, those assets are fully eligible for a step-up in basis upon their death. This means that the surviving spouse can inherit these assets with a new tax basis equal to the current market value at the time of death, potentially avoiding significant capital gains taxes if they choose to sell the assets in the future.

The Benefits of This Strategy

1. Maximizing the Step-Up: By ensuring that appreciated assets are owned solely by the spouse closer to death, the entire value of the asset can receive the step-up in basis, not just half.

2. Tax Savings: This strategy can result in substantial tax savings for the surviving spouse, as they would avoid paying taxes on the appreciation that occurred during the marriage.

3. Flexibility for Heirs: Heirs who inherit these fully stepped-up assets have more flexibility to sell the assets without worrying about large tax bills, allowing them to manage the estate more efficiently.

Final Thoughts

The step-up in basis rule is a powerful tool in estate planning, but its benefits can vary significantly depending on the state in which you reside and how assets are held. For couples in separate property states, transitioning appreciated assets to the spouse closer to death can be a prudent strategy to maximize tax savings and provide more financial security for the surviving spouse and heirs.

Given the complexities involved, it’s always advisable to consult with a tax professional or estate planner to tailor these strategies to your specific circumstances. Proper planning can ensure that you and your loved ones make the most of the step-up in basis rule, potentially saving significant amounts in capital gains taxes and preserving more of your wealth for future generations.