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Step-Up in Basis Impact: Understanding Its Role in Estate Planning

Navigating the intricate world of estate planning can be daunting, particularly when it comes to understanding the “step-up in basis.” This concept plays a crucial role in determining the after-tax value of assets and can vary greatly between a full and partial step-up.

The Step-Up in Basis Explained

As an asset appreciates, its value rises. When this asset is sold, the gap between the original purchase price (or “basis”) and the sale price is deemed a capital gain and is subject to tax. However, the game changes when the asset owner dies. The basis of the asset can then be “stepped-up” to its current market value, potentially allowing the heirs to sell the asset without bearing capital gains tax on the appreciation that took place during the deceased’s lifetime.

Jointly Held Property and Step-Up in Basis

It’s common for married couples to hold substantial assets in joint accounts. While this setup offers ease and clarity, it might not be the most tax-savvy. In separate property states, each spouse is generally viewed as owning 50% of the joint account. Thus, when one spouse dies, only half of the assets in the account qualify for a step-up in basis. Conversely, in community property states, both spouses are seen as owning the entire asset, leading to a full step-up in basis upon the death of either spouse.

For couples in separate property states, strategic planning can help achieve a double step-up in basis. One method involves moving appreciated assets from joint accounts or accounts held by the healthier spouse to accounts solely under the spouse’s name, likely to pass away first. This strategy, while effective, necessitates trust and open communication between partners.

The Current Landscape

In 2021, there were rumors about a potential decrease in the estate tax exemption for 2022. However, the Build Back Better Act, which proposed this change, did not pass. Consequently, the estate tax exemption for 2022 remains at $12,060,000 per individual. With portability provisions, a couple can protect over $24 million from estate taxes without advanced planning. Even with anticipated changes in 2026, the majority of taxpayers will likely remain unaffected by estate taxes for the foreseeable future.

Case Study:

The Thompsons and the Step-Up in Basis

Background: Introducing the Thompsons, Charlie and Sabrina, a married couple living in Virginia, a separate property state. They’ve amassed significant assets over the years, including a taxable brokerage account registered as ‘joint tenants with rights of survivorship.’ This account mainly holds shares of Maple Inc., which they bought for $200,000 ten years ago.

Unfortunately, Charlie recently passed away. On the date of his death, the Maple Inc. stock in their joint account was valued at $500,000. Given the separate property rules of their state, how would the step-up in basis apply to Sabrina?

When they initially bought the Maple Inc. stock, both Charlie and Sabrina were allocated 50% of the $200,000 purchase price, giving each a basis of $100,000. On Charlie’s date of death, his share of the Maple stock was worth $250,000 (half of the total value).
According to the step-up in basis rules for separate property states, Sabrina can treat Charlie’s share of the account as if she bought it for its value on his date of death. This means she can add the $250,000 value to her existing basis of $100,000.

After Charlie’s death, Sabrina’s total basis in the Maple Inc. stock becomes $350,000 ($250,000 + $100,000). If she decides to sell the stock at its current value of $500,000, she would only have a capital gains exposure of $150,000 ($500,000 – $350,000).

Case Study:

The Martins and the Individual Ownership Step-Up in Basis

Introducing the Martins, Robert and Emily, a married couple with unique asset ownership structures. Robert owns a beachfront property in Florida, which he bought for $300,000 twenty years ago. This property is held in a revocable living trust under Robert’s name. On the other hand, Emily owns a collection of vintage cars, valued at $400,000, solely under her name.

Sadly, Robert passed away recently. At his death, the beachfront property’s market value had skyrocketed to $1 million. Given that the property was entirely under Robert’s name and trust, how would the step-up in basis apply?

Since the beachfront property was held in Robert’s revocable living trust, the entire property value is included in his estate upon his death. This means the property is eligible for a full step-up in basis.
On the date of Robert’s death, the property’s market value was $1 million. Therefore, the step-up in basis rule allows the property’s basis to be adjusted to this current market value.

After Robert’s death, the new basis for the beachfront property became $1 million. If Emily decides to sell the property at its current value, she would not incur any capital gains tax, as the property’s basis has been stepped-up to its selling price.
However, Emily’s vintage car collection, which Robert had no ownership stake in, remains unaffected by his death. This means that if Emily were to pass away, the collection would receive its step-up in basis only at that time.

Understanding estate planning can be complex, especially when it comes to the “step-up in basis.” This principle significantly impacts the after-tax value of assets. While it can be intricate, getting to grips with it can be beneficial. The way assets are held, the strategies used, and the evolving landscape of estate tax exemptions are all important factors. With careful planning and open communication, these can be effectively managed. Despite potential shifts in the future, it’s likely that most taxpayers will remain largely unaffected. It’s a practical part of ensuring a solid financial future for you and your heirs.

For a personalized approach to navigating your estate planning journey, don’t hesitate to reach out for a consultation.

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