When can you use Stepped-up Basis?

Every long-term investor needs to know about the stepped-up basis loophole (also sometimes called the stepped-up cost basis loophole). It's a tax benefit Congress gives families who aren't rich enough to be subject to the estate tax but who diligently built wealth by acquiring stocks, real estate investments, or other property (such as construction equipment) throughout their lifetime and want to pass those assets on to their children, grandchildren, nieces, nephews, or other heirs after death. 

What is the stepped-up basis loophole? Under present tax law in the United States, when you die, the qualified stocks, real estate, and other capital assets that you leave to your heirs get their original cost basis wiped out entirely. That means your heirs can value that property at its fair-market value on the date they inherited the asset. 

Managed correctly, the stepped-up basis loophole is a close second to the twin combination of a Roth 401(k) and a Roth IRA in terms of amassing money in the most tax-efficient way for generations of your family. Under certain circumstances, it can even be preferable to an inherited IRA.

A Real-World Example

Imagine that, like one out of five families in the United States, you earn a minimum of $8,333 per month. You live below your means and don't have debt. Let's assume you financed the purchase of your home, but your mortgage payments are modest because you're conservative with your money. You plan on paying that off before you retire, though, so it doesn't cause you to lose sleep at night.

You decide that you're going to save 10 percent of your starting pretax income in a regular brokerage account or through direct stock purchase plans and their closely related sibling, DRIPs. You invest in a basket of stocks that compounds at average rates of return. (For the sake of simplicity, let's assume you only bought non-dividend-paying stocks, but the underlying concept is the same regardless.) You keep this up for 35 years. You never increase your annual savings by inflation, so it represents a smaller and smaller burden on your cash flow as time passes and the dollar loses purchasing power.

Over the years, you put aside $350,000 out of your own pocket. You end up with $2,710,244 sitting in your brokerage account. This represents an unrealized gain of $2,360,244.

If you sell the stock, you're going to have to pay federal capital gains taxes, as well as state and local taxes. Under a worst-case scenario (e.g., you live in Southern California or New York City), you'd be lucky to end up with $1,896,706, of which $350,000 represented your original principal and $1,546,706 represented your nominal after-tax profit before inflation adjustment. You then gift that money to your heirs in your will or through a trust fund. If your heirs turn around and invest the money in an asset that earns a 10 percent rate of return, they might enjoy a $189,671 annual increase in personal net worth.

If, instead, you qualify to take advantage of the stepped-up basis loophole without triggering the estate tax, you could pass the entire $2,710,244 to your heirs without the federal, state, or local governments getting any of it. All you have to do is leave the appreciated shares of stock, real estate property, or other capital assets to your heirs. When you die, the fair market value will be appraised (in the case of stock, this is often easy, as it is the market quotation) and the heirs get to act like that price—the inherited price—is their cost basis.

This stepped-up basis loophole gives your heirs two superior alternatives:

1. If they hold onto the stock or real estate and it continues to produce average rates of return, they're earning it on the higher asset level of $2,710,244, not the lower $1,896,706. This means they'd enjoy an increase in wealth of $271,024 per year, not $189,671. That's an extra $81,353 or 42.89 percent per year. Meanwhile, the $813,538 in additional equity sitting on their balance sheet can lower their cost of borrowing elsewhere or serve as collateral if they want to fund a new acquisition or development.

1. If they sell the stock, real estate, or another asset upon receiving it, they can pocket the entire $2,710,244. That is an extra $813,538 in real, liquid cash that would be available for your heirs.

Giving Stock or Property as a Gift While You're Still Alive

What happens if you want to give your heirs shares of appreciated stock or other property during your lifetime? They won't get to take advantage of the stepped-up basis loophole. Rather, they'll inherit your cost basis as if they had been the original purchaser on the same terms, at the same price, and on the same date that you did. For that reason, it's almost always a better idea to give cash or freshly purchased shares instead (where the market value and cost basis are comparable), and keep the appreciated stock until death.

One major exception to this rule is as follows: If you are going to go over the estate tax limits and you don't have a lot of cash on hand, you can use the annual gift tax limit exclusions to give appreciated stock, real estate, or assets to your heirs. That approach will help you lower the size of your estate and save on the taxes that you'd otherwise owe. If you make sure the final appreciated property is below the estate tax limits, then the rest of it gets inherited with the stepped-up basis loophole.

Be sure to consult with a qualified tax specialist before taking these steps to ensure that you're doing it all correctly.

Thanks to Joshua Kennon for pulling this together.