Can I Get a Step-up?

Recently, a financial planner asked me if I thought the federal government was going to eliminate the “step-up” in basis for assets of an estate.  I thought it was a distinct possibility.

Currently, when an individual dies owning certain assets, those assets receive a step-up (or a step-down) in basis. So, for example, if Mr. Smith purchases stock for $1 a share in 1980 and when he dies the stock is worth $10 a share, Mr. Smith’s children will inherit that stock with a basis of $10.  If the children turn around and sell the stock for $10 a share, the children will not realize a gain on the sale of the stock, so the children will not have to pay capital gains tax.

The same would apply for Mr. Smith’s home.  Assume that Mr. Smith purchased his home for $50,000 in 1970.  His home is worth $500,000 at the time of his death.  When his children inherit his home, the children inherit the home with a basis of $500,000.  When the children sell the home, the children will not realize any gain and will not have to pay any capital gains tax.

If you notice, I said the children may obtain a “step-down” in basis.  This is because the basis the children receive is pinned to the value at the time of death.  If Mr. Smith purchased a stock for $10 and it were worth $9 on the date of his death, his children would inherit the stock with a $9 basis.

In most instances, however, Mr. Smith owned the assets he died with for a considerable period of time and there is gain built up in the assets, so the children receive a step-up in basis.  The step-up in basis does not apply to assets on which Mr. Smith never paid tax.  For instance, there is not step-up in basis for IRA’s, 401(k)’s, or deferred annuities.  Since Mr. Smith never paid tax on the income in these assets, his children will not receive a step-up in basis upon his death.

The step-up in basis is a reward for the “punishment” of the estate tax.  When Mr. Smith dies, his estate might be subject to federal estate tax.  Because Mr. Smith’s estate is subject to estate tax, sort of a punishment, his heirs receive the reward of a step-up in basis.  The estate pays $XXX in estate tax, but the beneficiaries of the estate do not have to pay capital gains tax when they sell the assets they inherit.  The bright side of the estate tax.

The reason the financial planner was asking my opinion on the future of the step-up in basis is because of the happenings with the estate tax.  In the not-so-distant past, estates that had a value greater than $675,000 were subject to federal estate tax.  But the credit against the federal estate tax has risen steeply.  Currently, your estate would have to have a value greater than $11,700,000 in order to even potentially be subject to federal estate tax, and a married couple can easily shelter twice that amount, or $23,400,000.

Needless to say, very few (probably almost no one) pays estate tax.  I know when I mention these credits to clients and ask them if they have an estate tax issue given the credit, the universal reaction I get from clients is, “Ya.  I wish.”

The thing is, if so few estates are subject to the threat of estate tax, why are all estates receiving the benefit of the step-up in basis?  With the estate tax, the rally cry of those seeking to eliminate it was, “Why should I have to pay tax on assets my dad worked hard to obtain and paid tax on?  That’s double taxation!”  But the same argument cannot be made with the step-up in basis because dad never paid capital gains tax on the stock he bought for $1 or the home he bought for $50,000.  Given his heirs a step-up in basis is really a gift from the federal government.

So, do I see the federal government changing the current law with respect to estates and the step-up in basis?  Let’s just say it wouldn’t surprise me.  The irony is, before the credit against the estate tax began to rise steeply, fewer than 5% of estates paid tax, but the rich convinced most of us that the “death tax” was something we all had to pay.  Raising the credit so high has caused the “step-up” in basis, something we all (rich and poor) benefited from to come into question.