step-on-up

Though I like to step up on the dance floor with my version of the Sprinkler, Churning Butter, and other assorted moves designed to embarrass my wife and kids, that’s not what this topic is about. The step up in basis is one of the least understood topics we deal with during our lifetime.

WARNING: This and many other topics in this book deal with the subject of financial implications after someone passes away. Since statistics show that a vast majority of all mortals will die someday, we shouldn’t just bury our head in the sand.

The subject of Step-Up deals with the situation where you inherit money from your spouse, a family member or a friend.

NOTE: There are different rules for the deceased who live in a community property state versus a common law state. Those from community property states receive a double-step-up in the case of a spouse. A half-step-up is generally allowed in a common law state.

As an example of double-step-up in a community property state, meet “Donald” of Washington.

Donald loved to buy a certain kind of rental house. Some would call these fixer uppers, I might call them tear downs! When he passed away, his wife “Betty” was mortified with the prospect of having to own and maintain 20 of these houses, worth about $3 million dollars. The structures had been fully depreciated, so only the cost of the original land remained as basis. This basis was $300,000. Had the houses been sold while they were both alive, there would have been a huge capital gains tax to pay on the gain of $2.7 million.

I suggested she sell them. Betty said she could not sell them because of the tax. So I told her about the step-up in basis and how her new basis was now the fair market value at the date of Donald’s death: $3 million. So when she sold the houses, there would be no income tax owed. Her relief was enormous.

Had they lived in a common law state, the result would have been different. Only Donald’s half would have received the step-up, not Betty’s (hence the term half-step-up). So the new basis would be half of $3 million plus half of $300,000. The taxable gain from the sale after the date of death would therefore be $1.35 million.

Community Property State: Double Step Up
Common Law State: Half Step Up

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Example: John and Jane Live in California

Cost of Lot:     $100,000
FMV:      $500,000
Gain if gifted or sold:      $400,000

After John or Jane’s death, new basis is $500,000 ($300,000 if from Oregon).

Most assets receive the step-up. Assets that do not get a step up are all IRAs and retirement assets, as well as annuities.