The step-up in basis and why it matters more than estate tax

Estate tax affects a tiny fraction of estates. The basis adjustment on inherited assets affects nearly all of them, and it drives planning decisions in the opposite direction from estate tax minimisation.

What it does

Assets included in a decedent's estate generally receive a new cost basis equal to their fair market value at the date of death.

Which means the appreciation that occurred during the owner's lifetime is never subject to capital gains tax.

An heir who sells shortly after inheriting generally realises little or no gain, regardless of what the asset originally cost.

The adjustment works in both directions. An asset that has fallen in value receives a basis reduction, which is worth knowing since it eliminates a loss that could otherwise have been useful.

The size of the effect

Consider a property bought decades ago and now worth several times its cost.

Sold during the owner's lifetime, the gain is taxable, potentially with state tax and the additional tax on net investment income on top.

Inherited and then sold, the gain is largely eliminated.

The same applies to long-held shares, a business interest, or any appreciated asset.

For most families this is a considerably larger tax consideration than estate tax, which they will never pay.

The planning implications

These run counter to a great deal of general estate planning advice.

Do not gift appreciated assets during life where estate tax is not a concern.

Gifted assets carry over the donor's basis, transferring a tax liability that would otherwise have disappeared.

Gifting the family home to children during life is a common and expensive error for exactly this reason.

Consider which assets to spend and which to keep. Spending from accounts with little embedded gain, while preserving highly appreciated assets, produces a better family outcome.

Do not automatically sell appreciated assets to simplify a portfolio in later life, if the intention is to leave them to heirs.

For married couples, consider titling. In community property states, both halves of community property generally receive an adjustment on the first death, which is more favourable than the treatment of jointly held property in other states.

This is a genuine and under-appreciated advantage of community property jurisdictions.

What does not receive the adjustment

Important exceptions.

Retirement accounts. Traditional accounts contain untaxed income, and heirs pay ordinary income tax on withdrawals. There is no basis adjustment.

Which means an inherited traditional account is worth considerably less than a taxable account of the same nominal value.

Annuities with untaxed gain, similarly.

Assets in an irrevocable trust that are not included in the decedent's estate — which is the trade-off inherent in removing assets from the estate for estate tax purposes.

Gifts made during life, as above.

What heirs should do

Practical steps that are frequently missed.

Establish the date-of-death value and document it. For publicly traded securities this is straightforward. For property, a business or unusual assets, a professional appraisal is worth obtaining at the time.

Reconstructing a value years later is difficult and the burden of proof sits with the taxpayer.

Note that an alternate valuation date may be available in some circumstances where an estate tax return is filed.

Keep the documentation permanently. It will be needed whenever the asset is eventually sold, which may be decades later.

The policy uncertainty

Worth mentioning because it affects long-term planning.

The basis adjustment has been the subject of periodic legislative proposals, including proposals to limit or eliminate it.

None has been enacted, and the possibility means plans built entirely around it carry some risk.

The reasonable position is to take advantage of current rules while avoiding structures that would be seriously damaged by a change.

The community property advantage

Worth drawing out because it is substantial and little known.

In most states, jointly held property between spouses receives a basis adjustment only on the half owned by the deceased.

In community property states, both halves of community property generally receive the adjustment on the first death.

Which means a surviving spouse in a community property state can sell an appreciated asset shortly after their partner's death with little or no gain, where a survivor elsewhere would face tax on half the appreciation.

Several non-community-property states permit spouses to elect community property treatment for specific assets through a trust arrangement, which is worth investigating for couples holding substantial appreciated assets.

General information only, not legal or tax advice. Basis rules are technical and subject to change — consult a qualified tax professional or estate attorney.