When setting up an inheritance, taxes can be a tricky point to consider. Luckily, a step up in basis can help anyone who inherits an asset save big on tax costs. Further, double step up in basis is included and inferred as it is part of Texas state law. Texas is one of the nine community property states in the United States, and as such, we benefit from the characterization of property as being separate or community from the time and way it was acquired. This double step-up rule applies only in community property states. When one spouse dies, the asset gets stepped up in basis. When the surviving spouse dies, the asset gets stepped up in basis again.
What is a Step Up in Basis?
A step up in basis is what happens when an asset’s cost basis is reset for the heir to correlate with the property’s fair market value (FMV) when their benefactor died.
For example, let’s say that your mother leaves you a home that she originally purchased for $250,000. When she bequeathed the property to you, it had appreciated to a value of $750,000. With that, you would be able to enjoy a step up in basis from $250,000 to $750,000.
If you decide to sell the property, this step up in basis will greatly reduce your capital gains tax burden. Instead of paying capital gains taxes on the difference between $250,00 and the sale price, you would only have to pay capital gains tax on the difference between $750,000 and the sale price.
Depending on your unique situation, a step up in basis could save you thousands of dollars.
What is the Capital Gains Tax?
In order to fully appreciate the benefits of a step up in basis, it is critical to understand capital gains tax. You will pay capital gains tax on any asset that’s worth more when you sell than when you bought it.
For example, let’s say you bought a stock for $5. When you decide to sell the stock three years later, it is worth $15. With that, you would pay the long-term capital gains tax rate on the difference of $10.
The length of time that you hold onto the asset will affect your capital gains tax rate. When you hold an asset for less than a year, you will be taxed at the short-term capital gains rate. Short-term capital gains are taxed at your ordinary income tax level.
But if you hold onto the asset for more than 1 year, you will pay the long-term capital gain rate, which can be between 0% to 20%. It is worth noting that inherited property is always treated as a long-term capital gain opportunity.
Why Does The IRS Use The Step Up In Basis At Death?
The Internal Revenue Service (IRS) chooses to use the fair market value at the time of the benefactor’s death to determine the new value of the asset being transferred to help calculate the capital gains taxation of inherited properties. With this clear distinction, the IRS can more easily assess taxes on estates and gifts.
What If I Don’t Intend To Sell The Property that I Inherit?
When you inherit a property, you may not want to sell it. Although that means that you won’t pay capital gains taxes on the sale of the property, your future heirs will enjoy the appreciation that the property builds. If your heirs decide to sell the property, under the law in its current form, this can postpone taxes for generations to come.
Whenever an heir down the line chooses to sell, the seller will only have to pay capital gains taxes on the appreciation in the property’s value from the date of their surviving parent’s death. The heir will not have to pay capital gains taxes on all the appreciation that occurred since their great-grandparents bought the property minus whatever they paid.
What about a Step Up in Basis at the Death of a Spouse?
Depending on your state, you may be able to enjoy a step up in basis upon the death of a spouse.
Non-Community Property States
In every state but the community property states, spouses are treated as joint tenants with rights of survivorship (JTROS). With that treatment, you may receive a step up in basis for one-half of the property when a spouse dies. The other half of the increased value would be included in the deceased spouse’s estate.
Community Property States
If you live in a community property state such as Texas, things work a little bit differently. When the first spouse dies, the surviving spouse enjoys a step up in basis to both ownership portions of the property. With that, a surviving spouse that decides to sell will save on capital gains taxes.