Understanding Step-Up in Cost Basis
I hope everyone is enjoying the start of summer and finding ways to keep kids and grandkids busy! In our household, that is always the tradeoff when school is out – less stressful mornings in exchange for kids constantly saying, ‘I’m bored and/or hungry!’
Speaking of kids and grandkids, they will often be the inheritors of parents’ and grandparents’ assets and understanding the rules around leaving assets to the next generation is important and can save tax dollars.
What is a Cost Basis Step-Up?
One important rule to understand is the cost basis step-up rule. When it comes to estate planning and investing, one of the most powerful—yet often overlooked—tools is the cost basis step-up. This rule can significantly reduce the capital gains tax burden on inherited assets, saving heirs significant amounts of money.
Cost basis is the original value of an asset for tax purposes, usually the purchase price, adjusted for stock splits, dividends, and return of capital distributions.
Example of a Step-Up in Cost Basis
For example, if you bought shares of stock for $10,000 and they are now worth $50,000, your cost basis is $10,000. If you sell those shares, you pay capital gains taxes on the $40,000 profit.
A step-up in basis refers to the readjustment of the value of an inherited asset to its fair market value (FMV) at the time of the original owner’s death. This means that if you inherit an asset that has appreciated in value, your cost basis is “stepped up” to the current market value—not the original purchase price.
Example:
- Grandma bought a home in 1980 for $100,000.
- When she passes away in 2025, the home is worth $600,000.
- You inherit the home.
- Your new cost basis is $600,000.
If you sell the home shortly thereafter for $600,000, you owe zero capital gains tax, because there’s no gain based on your stepped-up basis.
Special Cases and Considerations for Step-Up
- Joint Ownership: If a property is jointly owned, only the deceased person’s share gets a step-up—unless you live in a community property state (like California or Texas), in which case the entire value may get stepped up.
- Trusts: Assets held in certain types of trusts (like revocable living trusts) still qualify for a step-up. Irrevocable trusts, however, may not qualify depending on how they’re structured.
- Gifts Before Death: Gifting assets before death passes along your original cost basis, not a stepped-up one. In some cases, holding the asset until death may be more tax-efficient for your heirs.
As prudent investment managers and planners, the only other thought I would add is that the “hold till you die” strategy might not always be appropriate. An investor also needs to weigh whether or not holding a single asset (like shares in one company) that might represent a significant portion of their net worth makes sense. If that asset loses significant value, then not only is the cost basis step-up option gone, but so is the inheritance. In some cases, it is worth paying the capital gains tax in exchange for diversification.
Stepping up isn’t always the best option, but it was nice to step up in elevation out in Sedona with Sarah Yakel at a recent conference. We learned a lot, had some fun (hiking, biking, and Pink Jeep Tour riding), and also heard a very interesting/funny author speak to our group. His name is Chris De Santis and his book is called “Why I Find You Irritating – Navigating Generational Friction at Work,” and I plan to read it this week. If it is anything like one of his presentation slides (below), it should be a good read.
And, one more picture from our Sedona trip. If you can see that white line going across the middle of the cliff, apparently mountain bikers ride along that! Hard to believe (unsurprisingly, it’s called ‘riding the white line’).
Cheers to a great summer!
Nathan