Taxes are a common concern when building a comprehensive estate plan, but there are ways to reduce the amount of taxes your children will have to pay on their inheritances. One such method is a step-up in basis, which can save your heirs a substantial amount of tax on assets that have gone up in value over time.
Inheritances and Capital Gains Tax
If you are leaving someone a property worth significantly more now than when you purchased it, the property will be subject to capital gains tax. Capital gains tax is assessed on the amount of profit an heir makes on the asset—in other words, the difference between the purchase price and fair market value at the time of inheritance.
Capital gains tax can also be assessed during a person’s lifetime. For example, imagine you purchased a stock for $10. Four years later, the stock is worth $200. If you decide to sell, you would have to pay capital gains tax on $190.
Another complication is that the capital gains tax rate is higher than other types of taxes. The exact rate will depend on how long you held the asset before selling.
- Short-term. If you hold an asset for less than a year, your profits will be taxed at the short-term capital gain rate—the same as your ordinary income tax level.
- Long-term. If you hold an asset for a year or more, your profits will be taxed at the long-term capital gain rate of 0% to 20%. Inherited property is usually treated as a long-term capital gain.
As you can see, high-value assets can bring an influx of wealth to your heirs, but they can also cause a significant tax expense. Fortunately, there’s a way to reduce the total amount of taxes owed: the step-up basis.
Step-Up in Basis Reduces Inheritance Tax Burden
A step-up in basis lowers the amount of taxes by “resetting” the cost basis. Instead of using the asset's original purchase price as the basis, heirs can use the property’s fair market value on the date of the original owner’s death. The adjusted higher value makes the taxable profit smaller, resulting in a smaller capital gains tax bill.