What is stepped up basis?

 

I’ve seen a lot of buzz lately about stepped up basis. I thought I’d help clarify what it is, what it could mean for you, and some proposed changes that could come into play in the future. All of the examples I lay out assume the assets are held in a non retirement status.

 

So, what’s stepped up basis?

Let’s break it down into two pieces – “Basis” and “Stepped Up”.

 

First, what is basis?

Basis is short for cost basis. It’s what you’ve invested in an asset. So – if you bought a stock for $10, the cost basis is $10. Why do you care about this? Because if you have growth in an asset, the gain – the difference between what you sell it for and what your basis is – when you sell, is taxed. Depending on the holding period and asset type, it may be taxed as ordinary income or capital gains. Based on current tax law if a stock is held over one year, it’s taxed at capital gains rates. Which like the ordinary income tax brackets, are tiered based on your income level. I’m not going to break down all the different pieces of this now, but look out for future blogs doing so!

 

An example. . .

Let’s continue with the above stock example. You bought a stock for $10, after a couple years, you sell it for $25. Your taxable gain would be $15, so you’d have to pay taxes on the “long term capital gains” you realized by selling the stock. Have I lost you? No? Good. Let’s keep going.

 

To make it more complicated, costs associated with the purchase are included in your basis. So, if you bought the stock for $10, plus you paid $2 in trading costs, your basis would be $12. This also translates to other asset classes as well. Real estate is a great example, though it gets complicated quickly. I’ll oversimplify, capital improvements and purchase costs are added to your basis, where maintenance or replacement costs are not. So, if you had a house you purchased for $100,000 and you did an addition for $20,000, your basis would increase to $120,000. Closing costs and fees paid associated with the purchase are also added into basis, but things like insurance are not (because it’s not a cost to purchase the house, it’s for the insurance on the house).

 

That’s the quick and dirty on cost basis.

 

Stepped Up

What’s the stepped up part of “Stepped Up Basis”? As I mentioned, when you sell an asset for more than what you paid, you have to pay taxes on the gain. It’s probably important to mention here that there are a lot of loop holes in Internal Revenue Code (IRC) to get around paying these gains, depending on property type and circumstances. Stepping Up Basis is one of those loop holes.

 

How do you get your property to step up basis? See, that’s how they getcha. . .You have to die.

 

At death, cost basis is stepped up to either date of death or an alternate date (I’ll ignore the alternate date option for simplicity). So, this really affects your heirs, your estate plan (which is part of your financial plan), or you, if you inherit assets.

 

Let’s build up a stock example more to illustrate. Your aunt owned a stock she bought for $1 many years ago. It’s now worth $150. If she sold it, she’d have to pay taxes on the gain ($149). If she dies and listed you as beneficiary, you would have the stock worth $150 and your basis would be $150 (the value on the date of death). Or to make it more meaningful, you could add three zeros, say she bought it for $1,000 and now it’s worth $150,000.

 

If she sold it before death, she’d have to pay taxes on the gain of $149,000. If she dies still without selling it, and her heirs inherit it, that gain is never taxed. It’s income (from investments) that never had taxes paid. If you inherit the stock worth $150,000, you can sell it and not owe any taxes on that money. At 20% (currently the maximum capital gains rate) she would owe $29,800 in federal taxes (ignoring state taxes). If she managed her finances a bit, she would more likely owe 15% on this gain. That’s the capital gains rate for those with Adjusted Gross Income (AGI) of $80,000 to $496,600 and filing Married filing Jointly (MFJ).

That’s what the stepped up basis is and how you get around paying taxes on income from gains on property.

 

What might change after the election?

There’s been a proposal by a candidate for president to eliminate the stepped up basis provision of the IRC. I’ve seen some rants & memes discussing how middle class families would be really hurt by this. If congress and the senate passed this without any additional qualifiers, yes, this would certainly cause anyone who inherits property to be taxed on the possible gains.

 

In the IRC, many of these types of rules exclude items that would hurt lower and middle class families. I would expect to see them make some carve outs; they might exclude primary residences, allow some limited amount of step up, or allow a step up up to a certain income level. That’s speculation and it’s impossible to predict the actions of politicians, but I wouldn’t be surprised to see them compromise to maintain some exemption here.

 

Who does this hurt?

I get it, if you are inheriting assets, paying taxes on that inheritance is painful. Most folks I talk to aren’t happy about paying taxes on anything. However, a move like this is really targeted at high income and high net worth families. First, look at the capital gains rates, in 2020, you don’t pay any capital gains if your AGI is below $80,000 for a MFJ couple. It jumps to 15%, as I mentioned earlier, but there’s a clear bias toward lower income earners.

 

Let’s say the step up rule is eliminated. You inherit your parent’s lifelong home when they pass away, there’s a taxable gain of $150,000 and you have to pay 20% capital gains tax on it – remember, your adjusted gross income (AGI) would have to be over $496,600 MFJ in 2020 to be at this tax level, it would be a bummer to owe $30,000 of federal taxes on the sale. However, if you’re selling the house, you’re fortunate enough to not need to live there. Still a major windfall.

 

This really penalizes those families who have a lot of assets and high income. Let’s say alternatively that you inherited $2,000,000 of different assets. Perhaps it’s a mix of multiple real estate properties, stocks, and other investments and the basis was $1,000,000, if you liquidated everything and realized a gain of $1,000,000 you’d certainly be in the 20% capital gains bracket. In that case, you’d owe $200,000 of federal income taxes. Again, still a major windfall, but a serious tax burden.

 

Estate Planning

Situations like this are where financial planners and estate planning attorneys can really be helpful. Having an estate plan is critical for every family and its importance increases as your assets increase. Planning for these events allows you to take steps to minimize tax liability. Tax changes can necessitate changes to your estate plan. If you don’t have a plan, today’s a great day to talk to an attorney or holistic financial planner who understands estate planning .

 

In this situation, if you were able to plan and stay in the 15% tax bracket by not exceeding the $496,600 of AGI, you’d save $50,000 in federal income taxes. That is certainly more savings than what it would cost to pay a professional for help.

 

Conclusion

Tax laws, rules about taxes, and loopholes will change over time. That’s inevitable. Today (2020), we’re paying very low taxes when compared to historical tax rates, so it’s almost certain rates will go up at some point. Maybe it will happen next year, maybe in 5 years, but I believe it’s inevitable. By taking advantage of estate planning and tax planning, you can minimize tax burdens, regardless of what the rules are at the time.

 

I don’t think making political decisions based on projections or speculation about taxes is a wise decision. If you want to make political change, vote. Run for office. Get involved.

 

If you’d like to discuss your financial situation or create a financial plan, Telos Financial would be glad to discuss a possible relationship with you. Contact us today to schedule an introductory meeting. Telos is a fee based, holistic financial planning firm serving Michigan’s high income and high net worth professionals, millennials, recent college graduates, and small business owners.

 

Thanks for reading the latest edition of Planning for your Purpose, Telos Financial’s blog, where I discuss different topics related to financial planning. CERTIFIED FINANCIAL PLANNER™ professional Dennis LaVoy is Plymouth, Michigan’s holistic financial advisor serving clients throughout the mitten as well as across the country.

 

The primary purpose of the blog is to introduce financial planning concepts and questions I receive from clients that I believe are important. I want to start discussions that will educate, benefit, and improve your financial life, ultimately, to help you focus on your telos!

 

Telos Financial is headquartered in Plymouth, Michigan and focuses on serving young professionals and their families. Dennis LaVoy is a CFP® Professional and a Chartered Life Underwriter®. Dennis founded Telos Financial and to provide fiduciary financial services to families across Michigan including Plymouth, Canton, Ann Arbor, Detroit, and throughout the states.

 

While the tax or legal information provided is based on our understanding of current laws and has been gathered from sources believed to be reliable, it cannot be guaranteed. Federal tax laws are complex and subject to change.

FSC Securities Corporation, nor its registered representatives, or employees, provide tax or legal advice. As with all matters of a tax or legal nature, you should consult with your own tax or legal counsel for advice. The views expressed are not necessarily the opinion of FSC Securities Corporation.