Step up in basis key planning concept

Steve Gammill
Steve Gammill

The term “basis” constitutes a critical concept in income tax law, yet one that’s difficult to grasp. Add to that what’s known as the step up in basis that results at death.

Let’s explore this issue in the context of two hypothetical clients I call Bill and Carole. Carole told me she and Bill had heard about a new way of providing for a double step up in basis if their trusts are drafted with that in mind. “What in the world is that?” she asked.

Let’s say Bill and Carole purchased shares of stock many years ago for $10,000. They also bought their home for $200,000. If they cash in that stock at its present value of $15,000 or sell their house at its fair market value of $350,000, they’ll realize a gain of $5,000 on the stock and $150,000 on the house. Those gains are subject to income tax. Disregarding any applicable exemptions, the combined federal and state tax on the gain will be approximately $1,000 on the stock and $30,000 on the home. 

Tax laws also provide, however, that upon a taxpayer’s death — let’s say Carole in this case — the tax basis of an asset that’s unsold and in the deceased taxpayer’s estate will receive a “step up” in basis so the person inheriting the asset receives the asset with a tax basis equal to the fair market value of the asset as of the date of the taxpayer’s death. More specifically, Carole’s half interest in the stock portfolio is valued at $7,500 at her death. The tax basis for capital gain tax purposes in the hands of her heirs is, then, $7,500. Without the step up, the basis would be $5,000. 

This is a clear tax advantage for those heirs. When Bill later dies, his heirs also will receive a step up in basis on his half interest in that asset because it’s passed on rather than sold before his death. 

Now there’s even yet another quirk to add to this already complicated mix. Assume Bill lives a number of years after Carole’s death. When Bill dies, the heirs — the children in this family’s case — will receive both halves of the asset. Carole’s half will carry a basis of the fair market value as of Carole’s date of death. According to our earlier calculations, the basis of that stock is $7,500. If the stock has then appreciated, which we all anticipate it will, there will be gain to recognize and tax to be paid when and if the children sell it. 

Bill’s half, on the other hand, will pass to the children with a basis of its fair market value as of Bill’s death. Let’s assume the date-of-death value of Bill’s half is $10,000. When the stock is sold by the heirs, half will have a basis of $7,500 and the other half $10,000. 

Carole’s question to me was whether there’s a way to get a second step up so the entire portfolio carries a basis of $20,000 at Bill’s death. Wouldn’t that be nice? Given our assumption the value of the portfolio is then $20,000, there’d be no gain to recognize.

My answer to Carole was a qualified “yes.”

If Bill, at Carole’s death, had inherited her half of the stock, then the entire thing would get a step up at Bill’s subsequent death. But Bill and Carole have a trust that hold’s Carole’s half so that while Bill has access to it during his life, it doesn’t belong to him. The result is only one step up. For important estate tax and creditor protection reasons, it’s the better practice to separate ownership at Carole’s death. The loss of a second step up has long been a disadvantage in such non-community property states as Colorado.

The short answer to Carole’s question is that there’s a fairly new planning strategy called the bounty clause that allows for a double step up. Most of us believe it will work as designed. It’s complicated, but will give people the benefit of estate tax avoidance, creditor protection and capital gain tax reduction.