One of the questions most commonly asked when someone inherits personal or real property is what are the tax consequences. The answer to this question can be complex, as the IRS treats different inherited assets differently for tax purposes.
Many assets you may inherit are more valuable now than they were when the person from whom you inherited them originally bought or otherwise acquired them. For these assets, known as appreciated assets, certain specific tax rules apply. If an inheritance you receive includes appreciated assets, those assets may require a step-up in basis in order to determine your tax obligations for them.
What is a Step-up in Basis?
When you inherit an appreciated asset, its value must be readjusted for tax purposes according to the asset’s fair market value at the time of inheritance. This calculation is known as a “step-up in basis.”
For tax purposes, the IRS considers the higher market value of each applicable asset as its current cost basis. Therefore, a step-up in basis, also known as a stepped-up cost basis, occurs in order to minimize the capital gains taxes you may need to pay on the given asset.
How Is a Step-up in Basis Calculated?
The IRS applies a step-up in basis to the transferred property’s cost basis as of the time of the original, bequeathing, owner’s death. Also termed the property’s tax basis for tax purposes, this amount is the amount in dollars that the taxpayer originally invested in the given property before bequeathing it. For any given property, this may include calculations of amortization, depreciation and other dispositions of property.
Examples of a Step-up in Basis
In the simplest of terms, if someone purchases an asset for $1,000 that increases in value to $10,000 by the time he or shedies and leaves it to an heir, the cost basis of that asset for tax purposes is its current market value, or $10,000. If the new owner of the asset ever needs to pay capital gains tax on that asset, that tax will be calculated based on the $10,000 cost basis, or the stepped-up cost basis, rather than on the asset’s original $1,000 purchase price.
Since capital gains tax is calculated on the difference between the asset’s cost basis and its current market value, an asset that receives a step-up in basis will be taxed on a smaller amount than if the capital gains tax was calculated based on the original market value.
Going back to the previous example, if an inherited asset now stepped-up in cost basis to $10,000 sold for $15,000 and was subject to capital gains tax, you would only need to pay that tax on $5,000, or the difference between the asset’s current market value and its stepped-up costs basis, rather than on $14,000, or the difference between the asset’s current market value and its market value at the time the person bequeathing the asset originally purchased or otherwise acquired it.
What Is a Double Step-up in Basis?
Regarding inherited assets and the step-up in basis, you may have heard that, in certain states known as “community property states” residents may be able to take advantage of what’s known as a double step-up in basis. This applies when someone inherits an appreciated asset that has already received a previous step-up in basis. A double step-up in basis can further lower the tax obligation on qualifying inherited appreciated assets.
That said, North Carolina is not a community property state and, so, does not allow for a double step-up in basis.
The Future of the Step-up in Basis
At the same time as it’s important to understand the step-up in basis in order to ensure you don’t overpay in taxes for inherited property, that knowledge may also someday soon be irrelevant. Many economists propose eliminating what they view as the unnecessarily complicated and unfair step-up in basis system because they consider it mostly a tax loophole benefitting exclusively the uber-wealthy. For instance, a millionaire may avoid capital gains taxes on equity holdings by placing them in a trust fund for an heir.
Proponents of eliminating the step-up in basis system propose replacing it with a much simpler lower capital gains tax. They argue that it isn’t difficult at all to calculate an asset’s precise value, even if it’s many years, or even a century, old.
Whether or not the rule ever gets replaced however, the step-up in basis system is currently in effect, which means it can apply to any inheritance you may currently receive. For that reason alone, it pays to know about it.
Where to Get Your Tax Account Questions Answered in Charlotte, NC
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To reach the only accountant Charlotte NC residents need, contact Scott Boyar, CPA online at sboyarcpa.com/contactus or by phone at (704) 527-2725.