Losing the Step Up Basis Could be a Step Back On Your Estate Planning | Massachusetts Estate Planning Attorney
A few weeks back, President Obama proposed, in his State of the Union address, that the “step up in basis” provision of the capital gains tax be eliminated. While Obama claims that he wants to eliminate a loophole for the rich, such a change could have a bigger impact on the average middle-class American.
Before I explain why, let’s review just what exactly what the step up in basis is. Certain assets, such as stocks, mutual funds and real estate, appreciate in value over time. Joe bought stock in Apple for $10. If it is now worth $1,000 and he sells it, he will have a gain of $900. That $900 gain is subject to something called capital gains tax. The gain is calculated by subtracting the sale price minus the basis, which usually is the purchase price. (There are cases where the basis gets adjusted but we’ll keep our example simple.)
There are certain instances where Joe may not have to pay capital gains tax. One such instance is if he holds onto that stock and don’t sell it before he dies. Instead, he transfers it to his heirs as part of his estate. They now own it and the tax that comes with it.
If his heirs then sell it for $1,000, must they pay tax on the $900 gain? The answer is no. This is because of something called the step up in basis. Upon the date of his death Joe’s stock “steps up” in value to $1,000. So if the market value is $1,000 on Joe’s date of death, and his heirs sell it for its stepped up value of $1,000, the gain will now be zero and all the unrealized gain tax from Joe’s lifetime disappears.
This can be a huge tax break for many families. For example, if Paul purchased Microsoft or IBM stocks many years ago and held onto them as they multiplied; he would have accumulated significant gains over the years. If he holds onto his stocks until he dies and then his children inherit it, the tax on all that gain is gone and they will owe nothing in taxes if they sell it. This could amount to tens of thousands of dollars tax-free for his family. On the other hand, if Paul was to transfer the stock to the children while he is alive they get his original basis, what is called a “carryover basis”. They’ll have to pay tax on all the unrealized gains based on the original price that Paul paid for the stocks.
Now that you know how the step up in basis works, next time we’ll tell you why President Obama’s proposal could miss the mark on targeting the wealthy and instead have a greater impact on middle-class America.
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