Estate Planning For The Long Run

Estate Planning For The Long Run

Estate Planning-Allowing for a Step-up in the Basis of an Asset

March 25, 2013


We have all heard the adage, “It’s not always what you say, but how you say it.” In estate planning, this principle can reworded as, “It’s not always what you give, but how you give it.” As you consider the assets you will give to others and who will be the beneficiaries of those assets, it is important to keep in mind the timing of the gift. The step-up in basis principle is one example of this.

A simple way to understand what a step-up in basis means is to use an example. Let’s say a man purchased some land years ago for the amount of $100,000 and recently decided to give it to his son. He can either give it to his son while he (the father) is still alive, or he can leave it to his son upon his (the father’s) death. To make it simple, we will say that the fair market value (the value the land can be sold at presently) is $200,000 in both scenarios. If the man gives the land to his son while he is still alive, the son automatically has to assume the cost basis of the land at $100,000, the same amount that it originally cost his father to purchase it. If the man leaves the land to his son upon his death, the son would assume a step-up in basis of the land at its fair market value of $200,000. This is what it means to have a step-up in the basis of an asset-to assume an asset’s value at its higher fair market value compared to its original cost. But why is this relevant and what implications does this principle have?

The tax implications are significant when dealing with the step-up in basis of an asset. To continue our example, after receiving the land from his father the son decides he wants to sell it for $200,000. If the land was given to him while his father was still alive, the son would have to pay taxes on the amount of $100,000, the difference between the fair market value and original cost, or the gain on the sale of the land. Now if the son received the land upon the death of his father, he does not have to pay any taxes because he would be selling it for the same amount that it is worth at the fair market value. In other words, the difference between the selling price and fair market value of the land is $0, therefore no taxes need be paid on the sale.

Using this example, it is evident that in many cases it may be wise to leave an appreciated asset upon one’s death rather than give that asset to a beneficiary while the donor is still alive. This will minimize the taxes to be paid, which can be very costly, in the event that he or she sells the asset during his or her lifetime.

Some people feel that giving assets away during their life will help avoid the time and expense of dealing with probate upon their death. However, people that choose to do this forfeit the beneficiary’s advantage of the step-up in basis principle. There are ways to both avoid probate and still allow for the beneficiaries to receive a step-up in basis of an asset. One such way is through creating a trust. In doing so, the assets placed within the trust pass on to the beneficiaries without the cost of probate and still give the beneficiaries the step-up in basis.