In our eighth installment of our updated review of The Wealth Cycle we take a look at a widely-used but often misunderstood estate planning tool –The Step-Up in Basis.
Read the Previous Posts in This Series:
- Phase 1: Wealth Creation
- A Wealth Creation Story
- Phase 2: Wealth Preservation
- On Preserving Wealth and Managing Risk
- Phase 3: Wealth Distribution
- Building a Cohesive Wealth Distribution Plan
- Case Study: Wealth Distribution Strategy
The step-up rule, which has been around for over 100 years, was originally implemented to prevent family farms from having to be sold to pay inheritance taxes as they passed from one generation to the next.
Since then it has become the most widely used tax planning tool for investors of all net worth ranges. When properly applied, it can literally wipe out tax liability for those who inherit assets. Though, it is important to note that it impacts heirs and has nothing to do with taxes levied on the assets of the deceased, which are controlled by estate tax rules, a topic we will get to in another post. Today, we focus on the impact to the heirs of your estate, and we can say without hesitation, that while they may one day mourn your loss, they will be major beneficiaries of the step-up rules in your absence.
In simplest terms, your heir to an asset does not inherit your cost basis-they get a new one that is based on the value of the inherited asset as of the date you pass away. So, a building you paid $500,000 for that is now worth $5,000,000 could be immediately sold by your heir for $5,000,000 tax free because their basis would be $5,000,000.
If that sounds like one helluva loophole, you are absolutely correct. In fact, it seems too good to be true every time we think of it. The only unfortunate thing about it is that you won’t be around to revel in beating the IRS out of millions in tax revenue. But, there is at least the satisfaction of knowing that you will someday.
Should your heir decide to hold the inherited asset for a time and it appreciates to $6,000,000, he or she only pays capital gains and state income tax on the additional rise in value when it is sold.
By the way, the step-up rule applies to all asset classes, not just real estate. Any asset you pass along to heirs gets a basis step-up. Pretty good deal, right? All your hard work and risk-taking goes to the benefit of your loved ones instead of the IRS. They can sell it all and pay nothing. What’s not to like about that!
That’s the rule in its simplest terms. However, there are other benefits to the step up in basis that you can enjoy while you are still around. Specifically, we refer to two variations; the partial step-up and the community property step-up, both of which can save millions of dollars in taxes. Let’s take a look at partial step-ups first.
The partial step-up comes into play when there are multiple owners in your ownership entity. Let’s say you own an asset with two siblings and the estate plan calls for surviving siblings to inherit the shares of those who pass away before them. In this case, when the first sibling dies, the basis for their one-third interest is stepped up to its current market value for the two surviving siblings. When the second sibling passes, another step up occurs and the last remaining sibling (you, hopefully) enjoys the spoils of both step-ups in establishing your own potential gain. This would drastically reduce the tax liability if you as the last surviving owner decided to sell the property and otherwise deploy your equity.
In our experience, we find that many existing owners do not know to take partial steps up into account in their decision-making. Instead, they assume the taxes would be the same as if they owned the property themselves all along.
Now let’s make an adjustment to our scenario that brings to light a situation that is quite common and often difficult. Assume that you and your siblings each agree to bequeath your one-third interest to your respective children instead of to each other. In this case, when the first sibling passes, his children get a full step up on his or her share. This means if the property was sold at a price that represents market value at the time of the death, his children would pay nothing in taxes, but you and your other surviving sibling would pay tax on your entire gain. You can see how this could create conflict with your sibling’s children if they wanted to sell and you don’t. Now, if the LLC that you created to acquire the property does not have specific language that establishes the rules for disposition, you may have a big family problem, and they are the worst kind of all.
The main take-away in our little multi-owner scenario is to plan ahead. Consider all possible outcomes and make sure there are mechanisms in place that will produce the desired result for all involved. Partial step-ups can be a catalyst for change, but the tax implications can be different for each person involved. In other words, they can create a windfall, a nightmare or some combination of both. This is why we are seeing more of our clients who own properties with partners or other family members deciding to sell or exchange their interests now while prices are near the recent market peak. They are choosing to pre-empt future conflict by taking definitive action when they are still in a position to control the situation.
So, we recommend that you give your entire plan a check-up at least once every year. Things change, lives change and the world is always changing around us. Proper understanding and application of the step up rule may be a crucial component of your estate plan. As we often say, it costs nothing or next to nothing to stay informed, but it could literally cost you a fortune if you’re not.
That’s it for now. We will take a close look at the step up rule for community property assets in our next installment. Stay tuned.
Leave a Reply
You must be logged in to post a comment.