Basis primer: Step-up vs. Carry-over

“Basis” is not something that is simple to explain these days. Up until last week, the basis rules that apply to decedents in 2010 were in limbo. This article WILL NOT cover the advanced estate planning issue of basis allocations in 2010 and how they relate to the federal estate tax. Instead, this is an elementary review of, you guessed it, “Basis.”

What is basis?

Basis is the value of an individual’s interest in property.

Why does it matter?

When someone inherits property, the value of that property will determine the amount of gain or loss that is calculated upon the sale of the inherited property.

In 2009, a person who inherited property received a step-up in basis – meaning that the value inherited was usually calculated on the date of death (with some exceptions). But in 2010, a person who inherits property takes something called carry-over basis.

When basis is “carried over,” the value of property inherited equals the amount that the decedent paid for the property when it was originally purchased (with some possible additions). Carry-over basis is not good for beneficiaries if the property was originally obtained for pennies and subsequently appreciated in value. When the inherited property is eventually sold, the gain may result in a hefty capital gains tax.

Example 1: Carry-over basis

George Sr. purchased a few shares of 3M stock many years ago for five dollars ($5d).  If he dies today, those few stocks are worth fifty thousand dollars ($50K). The inherited basis of $5d is “carried over,” meaning George Jr. takes the original basis of $5d. This means that when George Jr. sells the stock at today’s value of $50K, he will pay capital gains tax on $49,995 of the purchase price ($50K – $5d = $49,995).

Example 2: Step-up in basis

Same facts but George Sr. died in 2009.  George Jr. takes a step-up in basis.  His inherited basis is $50K (the stock’s value on George Sr.’s date of death) and sells the property for $50K.  Since there was no gain ($50K-$50K = $0), George Jr. does not have to pay capital gains tax due.

Howard Gleckman wrote an article explaining how the non-existence of federal estate tax this year does not help individuals who inherit valuable property with a minimal carry-over basis.  That is unless those individuals elect to pay estate taxes and then take a step-up in basis – one option of the Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 that was made into law on December 17, 2010.  We will have more on the new legislation in the coming weeks.

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