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Planning for Capital Gains and Losses

Minimize Taxes to Maximize What You Leave Behind

Understanding the “Step up in Basis” and How to Get It

What is the Step up in Basis?

If you have real estate, stocks or mutual funds and sell them during your lifetime for more than you paid for them, you will owe capital gains tax. If you own these assets at the time of your death, your spouse or child that inherits the asset does not have to pay the capital gains tax – essentially that tax is forgiven.

To understand how this works, you need to understand some tax terms. The “basis” is the amount you paid for the asset originally. If the asset grows in value and you sell it during your life, you will owe capital gains tax on the difference between what you sold it for and your original basis. However, when you die, these assets get a “step-up in basis”, meaning there is a new basis calculated at your death that erases the original basis. The new basis is equal to the value of the asset at death. The result of this is that no capital gains tax is due to those inheriting these assets even if they sell it. Also, should the spouse or child hold onto the asset then sell it years later, they will only pay capital gains taxes on growth of the asset since the date of death.

What is the problem?

It’s not as automatic as it sounds. Your heirs need to understand and remember that a step up in basis has occurred. That means they need to know and track what the fair market value of the asset was on the date of your death. When they later sell the asset, it is their burden to prove the new step up in basis value occurred. For investments, proof can be as simple as a financial statement that shows the date of death value. For real estate, it is an appraisal. In many cases, however, years pass before your heirs decide to sell the asset so the proof may be lost or hard to track down. Too often, heirs may simply not understand that they received a step up in basis and therefore end up paying capital gains tax on the entire amount! Attorneys, tax preparers, and financial advisors don’t always understand the step up in basis either, or simply many believe that it’s not their job to make sure the heirs claim the step up in basis. Tax preparers may think it’s the attorneys job; attorneys often believe the tax preparer should take care of it, and financial advisors may think the heirs’ attorney or tax preparer is responsible.

Are there other issues?

Another important issue for heirs is they can actually receive a step down. So if your stock portfolio lost value during your life, your heirs will receive a step down in their basis on your asset. The step down prevents them from being able to sell the stock and claim a capital loss on their income tax return.

Some Solutions

The easiest solution is simply to educate your heirs. Teach them about it now – don’t assume that someone will explain to them what the step up in basis is! Also, estate planning and elder law specialists often use trusts that are specifically designed to maximize the advantages of a step up in basis. For example, some trusts can help prevent a step down in basis. The trust uses a concept called “formula general powers of appointment” which is a fancy way of saying that the trust is created so that the only assets included in the deceased’s estate are those that gained in value. In this way, only the assets that have grown in value get a step up in basis and assets that have lost value will avoid a step down in basis. These special trusts are designed to optimize the step up in basis which can maximize the overall tax savings for your heirs.

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*Dually certified by the National Elder Law Foundation as Certified Elder Law Attorneys and the Ohio State Bar Association as Specialists in the Area of Elder Law.