Step into the grave,
Then your capital gains will
Step Up in Basis

In last week’s FiKu, we looked at Basis. Basis represents the already-taxed dollars used to purchase an appreciating investment.

Basis is a crucial concept to understand when working with taxable (aka “non-qualified”) accounts. The difference between a taxable account’s value and its basis is unrealized capital gain, or loss. When selling stocks or funds to generate cash, knowing the tax implications of that sale will tell you how much money you get to keep vs. how much goes to Uncle Sam.

Given enough time, taxable accounts invested in stocks, ETFs, or mutual funds, will almost certainly have unrealized capital gains. If you look at the history of the stock market going back to 1872, no one investing in a diversified portfolio representing the total market would have lost money as long as they stayed invested for 20 years.

So, what happens if you hold an appreciating asset for decades? You could have a significant unrealized capital gain. A capital gain is unrealized as long as you don’t sell the investment that created it. When the investment is sold, the capital gain is realized. When the realized capital gain becomes a line item on your taxes that generates a bill, then the capital gain has become a recognized gain.

But what if you hold onto your investment for your entire life, and die with a highly appreciated non-qualified asset? When that asset passes to a beneficiary, are they stuck with a big tax bill?

The answer is no. The tax code allows for the basis in a non-qualified investment to “step up” to the fair market value of that investment at the time of the owner’s death. Helpfully, this does not apply if the asset in question has an unrealized capital loss. If the fair market value of the investment at the time of death is less than the basis, then the beneficiary can sell the investment and get a capital loss deduction.

The favorable treatment of basis in an inherited taxable account is one of the crucial differences between qualified and non-qualified accounts. A qualified account, like a 401(k) or Traditional IRA, qualifies for a current year tax benefit for the original account owner. Income earned this year avoids tax when it is used to contribute to a qualified account. The basis in the account is always zero, and all funds within the account get to grow tax-deferred as long as they stay within the account.

But, when a qualified account passes from the original owner to a beneficiary, the tax bill comes due. Beneficiaries must liquidate the account within 10 years of inheriting it, and they will pay ordinary income taxes on every dollar in that account.

The price of all the “qualified” tax benefits enjoyed by the original owner is the ordinary income tax bill paid on withdrawals.

Non-qualified accounts have a more favorable set of rules regarding inheritance. A taxable, appreciating asset – real estate and taxable investment accounts are common examples – receives a Step Up in Basis when they pass to a beneficiary.

Suppose someone bought a house in the early 1980s for $50,000. They live in the house for their entire life, making improvements along the way. The homeowner passes away in 2022, leaving the house to a beneficiary. Between the purchase price and the improvements, the original owner’s basis was $200,000. But at the time of death the house is worth $1,000,000. Before the homeowner died, the house had an unrealized capital gain of $800,000.

But, since the house passed to a beneficiary, that beneficiary gets a step up in basis. The basis steps up from $200,000 all the way to the fair market value of the house at the time of death. The fair market value of the house is $1,000,000, and now so is the basis. The beneficiary can sell the house and collect all the sale proceeds without any tax implication.

The Step Up in Basis rules make investment in taxable accounts and real estate an excellent idea for people looking to pass wealth to future generations. It also means investors should be careful about gifting assets in the waning years of life. Gifts don’t get any special tax treatment. Any unrealized gain within a gifted asset passes to the recipient of the gift.

Using the example above, suppose the homeowner gifted the house rather than letting it pass to a beneficiary after death. Whoever received the gift would also receive the original basis - $200,000. When the original owner passes away, the gift recipient gets no step-up in basis.

Of course, the tax code changes nearly every year, and the Step Up in Basis rules have been subject to scrutiny recently. Fortunately, nothing is changing for now.

If you want to look at how non-qualified investments can be used in your portfolio, or get clarity on how assets in your portfolio will pass to the next generation, we’d be happy to help.