Client Question: Step up

July 10, 2024

In working with a client this week on an inherited account, the topic of step-up in cost basis arose. This is an important item to understand when someone passes away (and you inherit their assets) so I thought it was worth covering it herein.

What is cost basis?

As a reminder, cost basis is the original cost for obtaining an asset. It typically will include the purchase price and any associated fees. During the time the asset is held, the cost basis may also increase for any additional money spent on the asset. For examples, the cost basis of a stock is the price you paid on the date you acquired it – and would be increased if you bought more at a later date. The cost basis of a home is the price you paid for the house, plus any significant capital expenditures over time (like a renovation, new plumbing ,etc).

Why does cost basis matter?

Cost basis is used to determine the capital gain on an asset, which is the difference between the fair value and cost basis of the asset. Under current tax law, capital gains are taxable when realized (ie: when the asset is sold). As a result, having proper records of cost basis on your assets is essential. For stocks, broker/dealers (ie: firms that custody your assets) track cost basis on your behalf. However, for other assets such as your home, you will need to keep those records

What is meant by step-up?

Under current US tax law, when someone passes, the cost basis of their assets is marked to the current fair market value on the date of their passing (ie: stepped up). (In some cases, a date up to six months after their passing may be used so work with an estate planning attorney and tax advisor as needed). This step-up in basis to current values effectively wipes away any capital gain on the decedent’s assets, removing capital gains tax implications for their heirs.

How is step-up processed?

For investment accounts, broker dealers will handle the process for you. There is typically a form that needs to be completed but beyond that, they will handle the actual adjustments of the cost basis amounts. It’s advisable to still complete your own review and ensure everything looks in order. For other assets (like a home), you would need to determine the fair value and keep records to support the step-up

What assets don’t receive step-up?

Some assets don’t receive a step up, including bank accounts, CDs. 401ks and other employer pans, pensions, and annuities. This is due to the nature of these assets – namely that capital gains taxes don’t enter the equation. You are taxed on earnings/distributions in these accounts – not capital gains, so there is no need for the basis adjustments.

As you can tell, this tax provision can prove to be a major benefit for heirs. Be sure to keep it in mind if you are ever faced with inherited assets and work closely with your advisors to ensure it’s handled properly.

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