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Why Tax Planning is Important for Estates of All Sizes: Section 1014 and the Basis Step-Up at Death

Updated: Sep 19, 2018

Thanks to the Tax Reform Act of 2017, an individual can pass $11.18 Million in assets at death without incurring any estate tax in the year 2018. This means a husband and wife would not need to worry about the estate tax until their net assets grow to over $22 Million.

Does this mean the average American (or even the relatively wealthy one) can ignore tax implications of estate planning as long as their net worth is less than $11 Million? The answer should be a resounding no. While the 2017 tax law overhaul has certainly inspired much hypothesizing about new strategies for the ultra wealthy, a less flashy and often overlooked aspect of tax planning remains alive and well. The Basis Step-Up at Death (I.R.C. Sec. 1014) can provide a tax benefit regardless of overall net worth. Ignoring this provision, however, can result in significantly more taxes paid and an overall decrease in the amount available to pass to beneficiaries. Unfortunately, individuals with otherwise simple estate planning goals may not be fully advised on this topic if they do not seek tax specific advice.

What is the Basis Step-Up at Death?

In simple terms, the Step-Up allows beneficiaries to pay less tax on the sale of an inherited asset than the original owner would have. Below is a very simple illustration of how the Basis Step-Up at Death operates:

  • Scenario #1: You buy and sell an asset while you are alive. You buy a share of stock for $10. Because you paid $10 for the share, you take a basis in that share of $10. Later, you sell that share for $100. You would recognize $90 in capital gain ($100 sale price - $10 basis = $90 capital gain). That $90 of capital gains will be reported on you tax return and taxed accordingly.

  • Scenario #2: You buy and asset and hold it until your death. Now let’s say you held on to that share of stock until you died and you left it to your child, Rick, in your will or through a trust. Rick immediately sells the share for $100. Rick will recognize zero capital gain and pay zero taxes on that $100 (we’ll assume the share’s value was $100 when you passed away). The Basis Step-Up at Death increased Rick’s basis in that share of stock to its value at the time of your death. Now, the calculation looks like this: $100 sale price - $100 basis = $0 capital gain.

This rule applies to all capital assets that are passed to beneficiaries. Some common types are real estate, stock, and ownership interests in family businesses. There are additional benefits to increasing the basis in certain depreciable assets, but that is beyond the scope of this article.

While the Basis Step-Up at Death has been referred to as a loophole by some, it requires no complex legal structuring to take advantage of and is available to individuals and their beneficiaries regardless of net worth (provided the individual owns appreciated capital assets when they die). Additionally, the current owner of assets must die in order for beneficiaries to benefit from Section 1014 (no gifting or other transfers while you are alive will qualify).

How to Take Advantage of This Tax Benefit?

The simple answer is: hold on to assets with lurking capital gains until you pass away. Obviously, that answer glosses over the many complications associated with estate planning. Below is a simplified explanation of the steps we go through when looking at the Basis Step-Up at Death in relation to a client’s estate plan:

  1. Reviewing all assets to identify appreciated capital assets that could benefit from the Step-Up;

  2. Quantifying the possible benefits of holding on to appreciated capital assets until death vs. selling or transferring before death;

  3. Incorporating that information into the client’s broader planning goals and current financial needs.

In some cases, clients simply must sell an asset in order to support themselves. Other times, a client’s desire to cash out an asset (often a family business) outweighs the possible future benefit to beneficiaries of holding on to it. There may also be questions of how the value of an asset will fluctuate in the future. Regardless of the final result, we believe that understanding the possible benefits of holding assets is extremely important for clients to have when making these types of decisions.

The following example illustrates a simple case where failure to consider the Basis Step-Up at Death costs beneficiaries and increases the total tax paid.

Grandparent is 85 years old and lives comfortably off savings and retirement plan income. She also owns 5 acres of vacant farmland that she purchased 50 years ago for $1,000. Due to increased development in the area, the market value of the land is now $500,000. Grandparent does not need the cash from the sale of land to support herself but wishes to leave everything she owns to her only Grandchild.

Scenario #1: Grandparent sells the land and leaves the resulting cash to her Grandchild

Grandparent will incur Taxes on $499,000 of capital gains ($500k sale price - $1k basis = $499k capital gain). Even if Grandparent had zero other income in that year, she will still pay approximately $73,000 in taxes on the sale of the property.

Scenario #2: Grandparent has her will amended to leave the land to her Grandchild

Several years after Grandparent amended her will, she dies and the property is transferred to Grandchild according to the will. At the time of Grandparent’s death, the value of the property was $500k. Shortly thereafter, Grandchild sells the property for $500k and recognizes zero capital gain ($500k sales price - $500k stepped up basis = 0 capital gain).

Result: Grandparent paid $73K in taxes and Grandchild received $427k in Scenario #1. Grandparent paid $0 in taxes and Grandchild received $500k in Scenario #2.

It is easy to see why the Basis Step-Up at Death is so crucial for individuals to consider when planning their estates. Unfortunately, the Grandparent in the above example might never receive any such advice and would have no reason to believe that holding the asset produced any benefit.


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