Mattson Financial Blog

It’s Time to Talk About Step-Up in Basis!

Step-up in basis is the readjustment of the value of an appreciated asset for tax purposes upon inheritance.

Wow, is that a mouth full or what? Let me explain.  

How is Step-Up in Basis Calculated?

Let’s say a parent bought a second home in Florida in 2000 for $200,000. When it was inherited by the children as beneficiaries, it was worth $500,000. The beneficiary’s potential tax basis is $300,000 (the original cost minus the new present value). However, under the current tax code, the new cost basis is inherited at the value at the time of death of the parent. In other words, no taxable gain if sold at the new value at death.

Now, when one spouse dies, the surviving spouse receives a step-up in cost basis on the asset. In other words, an inherited asset gets stepped up twice in a community property state: once for the surviving spouse and a second time for the ultimate beneficiary.

There are assets that do not presently qualify for a step-up basis: 401(k)s, IRAs, and similar deferred retirement accounts like pensions, tax deferred annuities, and certificates of deposits (to name a few). Currently, long-term capital gains of high earners are subject to the highest tax rate of 20% plus the 3.8% net investment income tax (NIIT) when the gains are realized (sold).

As part of President Biden’s American Family Plan (AFP), the White House proposed two major tax increases on accumulated wealth, adding up to a whopping 61% tax on the wealth of high earning taxpayers. In my opinion, this will be devastating to homeowners, the real-estate industry, farmers, and small business owners who have all of their wealth tied into their businesses.

The American Families Plan would tax unrealized capital gains at death for unrealized capital gains worth over $1 million. With home prices soaring, and a modest retirement account, many Americans will fall into this category.

Second, Biden wants to tax the capital gains of millionaires at ordinary income tax rates, which would be levied at his proposed top rate of 39.6%. Added to the NIIT, it would mean a combined top tax rate on capital gains of 43.4%, compared to 23.8% today. In addition to taxing unrealized capital gains at death at ordinary income tax rates, large estates would also be subject to the current estate tax of 40% above an exemption of $11.7 million per person. 

With trillions of dollars of debt owed by the United States government, I feel we could be seeing these amounts rolled back to 1980 levels of $1.2 million per person or $2.4 million per estate. In 2012, the estate exemption went from $10 million estate down to $2.4 million estate, a decrease of $7.6 million exempted in one year’s time.

The joke was if you had over a $10 million estate, you wanted to die in 2011 — not in 2012. There was even a Law & Order episode of family members sending their loved one to a certain hospital, as the hospital was run by a CPA of the wealthy and wealthy terminal patients were terminated in the so-called opportunity year so the taxes would not have to be paid in the following year.

All of this means we will see higher tax rates and now higher inflation. These two together will decimate most wealthy individuals if not addressed earlier in life. I recently had a wealthy individual approach me and ask about her $7.9 million estate and to review where she was “tax wise.” 

There were many things we could do; however, she was 89 years old, and the items we needed to discuss would require us to share with her beneficiaries these tax strategies. She didn’t want to bring them into the fold of information and learn how much wealth she had accumulated.  

There was already family dysfunction and adding wealth into the mix would only worsen the situation for her. Remember what we always say, “Money makes people funny.” So, she determined her estate will probably pay the added estate costs, if the new rules go into effect, and she’ll pass the IRS tax burden to her dysfunctional family — $2.4 million dollars.

If I told you the IRS has a plan in which you can pay the taxes at only 30% of the taxes normally due, and they will allow you to pay these taxes a little each year over your lifetime, would you be interested?

Now is the time to review your trust and make sure everything is properly funded. Review what you will spend and give away in your lifetime. Then determine what taxes you are willing your estate to pay at the end of your life. Once you do the math, we can determine what the discounted rate of 30% would be and how we put that plan into place.

Thanks for listening,

–Gary Mattson

P. S. It’s called a life insurance policy that you buy now, it pays out on the second person’s passing, to pay the estate taxes due. And, if the terms of the tax rate go back down, your estate gets the added value This maximizes and leverages your estate dollars to an even higher rate for those you love or charities you value, making you the best steward possible.