In a previous entry I discussed the difference in taxation of capital gains property versus ordinary income property. That piece discussed what happens on your Form 1040. This piece looks ahead to your eventual mortality. What happens when you die and bequeath these assets to your heirs?
A Step-Up in Basis Example
Previously I used the example of a stock that I bought at $100. Now say I leave it to my daughter at my death, and it is trading at $120 on the day I die. How is she taxed? Since stock is capital gains property, she gets a step-up in basis to the date-of-death value. This means that she does not inherit my original basis of $100 — on the date of my death the stock is worth $120, so $120 becomes her new basis. That $20 gain is therefore never taxed. She could turn around and sell the stock the next day for $120 and have no taxable event. If she sold it two months later for $130 per share, she’d have a $10 long-term capital gain. Remember, her basis is $120. How is the gain long-term when she only held the shares for a month? The gain is always treated as long-term on inherited property.
What Are Capital Assets?
What types of assets qualify for a step-up in basis? Capital assets — those which are held for a period of time, are subject to market price fluctuations, and are sold at a profit or loss. Think of stocks, bonds, mutual funds, real estate (though not retirement account assets), and business interests.
Another Step-Up Example
Here’s another example. Say your mother says to you, “Go ahead and put the Microsoft shares into your name, so they won’t have to go through probate when I die.” How generous! But a bad tax move. It turns out Mother and Dad bought 1,000 shares of MSFT way back when for roughly $10. As of early 2020, MSFT was trading at $224.97 per share, so the position was worth $224,970. The unrealized gain is $224,960. If you transfer the title to yourself, she has made a reportable gift to you (that’s another tax story for another day), and her very low basis becomes your basis — meaning you would owe capital gains taxes on $224,960 when you sell. What would a smart son do? Say, “Oh no, Ma — it’s your stock. You keep it and feel comfortable. I can wait.” You would ask her to re-title the account as Transfer on Death (TOD) so there won’t be any probate. The result? You inherit; your basis steps up to the date-of-death value — and there is no tax due if you turn around and sell the position. That’s $224,960 of gain that is never taxed. Using a capital gains rate of 15%, that is $33,744 that never found its way to the IRS.
Ordinary Income Property
What assets do not qualify for the step-up? Ordinary income property: interest received from the bank, annuity gains, and any money in a retirement account or IRA.
Annuities do not get a step-up in basis, since they are ordinary income property rather than capital gains property. There’s a clear trade-off with annuities: you gain income tax deferral of all gains while you’re alive, but your beneficiaries will pay ordinary income taxes on the gains over your basis. Sort of a high-class problem — I wouldn’t complain.
Retirement accounts also do not get a step-up in basis. You made tax-deductible contributions to your IRA and 401(k), so what comes out as distributions is ordinary income — and it is also ordinary income to your beneficiary. When they eventually distribute from Dad’s IRA, the full amount is income-taxable. Again, a high-class problem. If, for example, a beneficiary received and distributed $100,000 from Dad’s IRA, they have an additional $100,000 in income that year, which pushes them into a higher tax bracket.
Please also see my blog post on Ordinary Income taxation vs. Capital Gains Taxation.
