How the Step-Up Basis Loophole Works | Trust & Will (2024)

Loopholes – you may not always use them, but when you do need them, you’re sure glad they’re there. And when dealing with estate planning, there are loopholes that you might want to make use of. Whether it’s planning for how your own estate will be passed down to your loved ones or preparing for the responsibilities that can come with inheriting someone else’s estate, knowing some ins-and-outs of estate planning strategies can help you.

One loophole that is used often amongst people who inherit assets that have gone up in value over time is the Step-Up in Basis loophole. If you want to know more about why you may want to take advantage of the Step-Up in Basis law, why it’s an important part of inheritance tax laws, and how it can affect your estate planning, keep reading.

What is the Step-Up in Basis Loophole?

First, let’s talk about what Step-Up in Basis means. The term basis means the amount that was paid for an asset. A Step-Up in Basis means that the asset’s value has risen from the time it was purchased. The Step-Up in Basis value of an asset is calculated by assessing the fair market value of that asset on the date of its original owner’s death, upon which the asset is passed to a designated heir, often through an Estate Plan.

The Step-Up in Basis loophole is used to circumvent capital gains taxes, or to pay the least amount of this type of inheritance tax as is legally possible. This loophole can be used on inherited assets that have appreciated in value from the time they were purchased.

Step-Up in Basis and Capital Gains Tax

The capital gains tax is something that must be paid by those who inherit certain types of assets and then sell them after a specific amount of time. The amount of tax owed is calculated based on the profit made by selling the asset. For anyone who inherits property – such as real estate, stocks, or bonds, to name a few types of appreciating assets – and intends to sell any or all of that asset after holding it for a year or more, capital gains tax will apply. The Step-Up in Basis law readjusts the value of an asset to reflect its appreciated value at the time it changed hands via inheritance. This gives a new starting point from which to calculate the profits of a sale – most often to the advantage of the seller. The readjusted higher value means the profit from a sale is smaller, and thereby a smaller capital gains tax bill will be due.

How does the Step-Up in Basis Loophole work?

Think about what things used to cost in your grandparent’s day, and in your parent’s day. We’re not just talking about the cost of a gallon of gas or what bread cost back in the day. High-value assets such as real estate and stock are made to go up in value. They are invested in accordingly. And while markets fluctuate and not all assets appreciate at the same rate, if someone has held onto certain assets throughout their lifetime, chances are those assets are worth more now than they were in the past.

But what happens when an inherited house that was purchased for five figures is now worth several times its purchase price? Yes, if the beneficiary decides to sell it, they may be looking at a massive profit. But with a massive profit comes a massive tax bill. Unless the Step-Up in Basis Loophole is used.

For instance, Mr. A inherits a well-maintained older house that was originally purchased for $60,000 and is now worth $300,000. He sells it for $310,000 -- slightly over his asking price. He’s happy with his profit of $250,000. But he does not use the Step-Up in Basis Loophole, and owes capital gains tax on his quarter-million-dollar windfall. He’s a little less happy now.

Mr. B also inherits an old house that was originally purchased for $65,000. Real estate is booming in the area and the house is now worth $375,000. After making a few repairs, he sells it for $410,000. He made sure to use the Step-Up in Basis loophole and had the value of the house readjusted to $375,000, its market value when he inherited it. Considering its readjusted value, Mr. B’s taxable profits sit at just $35,000 – he will owe a significantly smaller capital gains tax than Mr. A will.

Can all assets be Stepped-Up?

The Step-Up in Basis Loophole cannot be used on every type of asset. Assets that provide a payment but cannot be readjusted to reflect an increase in value, such as 401K accounts, IRA accounts, Annuities, and Pensions are some of the assets that are exempt from the Step-Up in Basis Loophole. Assets that can be expected to appreciate in good market conditions, such as real estate, stocks and bonds, and full or part ownership of a business, can have their worth readjusted using the Step-Up in Basis Loophole.

Estate Planning Alternatives to Step-Up in Basis

Heirs benefit from using the Step-Up in Basis Loophole in certain conditions. But since each estate planning scenario is unique, it’s best to consider what will be most advantageous to an estate and its heirs. The Step-Up in Basis Loophole is most often used in a specific sort of scenario: a person has inherited an appreciating asset, held onto it for over a year, and then sold it at a profit. This loophole would not be used if the asset is to be sold immediately after it is inherited, or if the heir intends to hold onto the asset long-term (live in the house as opposed to selling it.) Property may also have been transferred to heirs through a Trust before or after its original owner’s death.

Planning for the future of your Estate with Step-Up in Basis and more

Learning how and when to use the Step-Up in Basis Loophole is just one of the many smart estate planning strategies you may need to know. Here at Trust & Will, we can help you create all of the customized, state-specific estate planning documents you need. If you want to know where to start, take our free quiz now. Consider getting started today!