This Tax Strategy Is to Die For -- Literally

If you ask your accountant the most effective way to save on taxes, their answer might surprise you. One of the most powerful tax avoidance strategies, the so-called step-up in basis, doesn't apply until after you die. What is the step-up in basis, and how could it save you big on taxes? Read on to find out.

What are capital gains taxes?

In addition to the income taxes that most Americans are familiar with, capital gains on the sale of assets are a very common way that the government collects revenue from taxpayers. If you've sold stocks, bonds, mutual funds, real estate, or even a stamp collection, you've probably paid capital gains tax.

How much you owe in taxes when you sell an asset is directly related to how much you paid for the asset when you first bought it. This purchase price, known as basis, sets a "floor" on the value of the asset for future tax purposes.

Note: Other factors, such as material improvements to and depreciation of a property, also affect basis, but the purchase price is often the majority of the carried basis.

Basis is important, because when an asset is sold, capital gains taxes apply to the growth of the asset above this "floor." Simply put, if you buy a share of stock for $50, and later sell that share for $60, you'll pay capital gains tax on the $10 of appreciation, not the $60 sale price. Capital gains rates are lower than income tax rates, but can add up if the value of an asset has grown for years, or even decades.

"Step-up" in basis

One major provision of the tax code is known as the step-up in basis rule. With an estimated $116 billion impact on tax revenue over the next decade, the provision sometimes allows those with highly appreciated property to avoid capital gains tax entirely.

The idea is simple: when a taxpayer dies, the basis of an appreciated asset rises to the value of the asset on the date of death, or shortly thereafter. The step-up rule applies no matter what price the asset was originally purchased at.

If sold by an inheritor at that time, effectively no capital gains tax is ever collected on the elevated value of the asset. And for some taxpayers, that could save tens of thousands or even millions of dollars in taxes. If you or a family member have large investment gains, consider discussing the tax-saving superpower of the step-up in basis rule with a qualified tax preparer.

The power behind the step-up rule lies in the ability to pass on well-performing investments to one's heirs. By automatically raising the "floor" of an asset's taxable value, the rule broadly allows deceased taxpayers to pass on their gains without incurring tax liability. For this reason, many inter-generational givers choose to gift assets after they die instead of selling those assets, paying tax, and then gifting cash while living.

The "step-up" rule in context

The step-up rule is not without controversy. In recent years, the provision has come under scrutiny due to its disproportionate effect on the ultra-wealthy. The rule only benefits those with highly appreciated assets, so does not apply equally to all taxpayers.

Prominent politicians, including President Biden, have proposed changes to the tax code that would reduce or eliminate the loophole. Approaches such as a wealth tax have gained traction in recent years, and may play a role in reshaping the tax code in future years. While no such changes have come into law yet, there appears to be an appetite for a change to the step-up rule in the future.

Capital gains tax is one of the pillars of the American tax code, and relies heavily on basis to determine how much of a sale is taxable. The code allows for a step-up in basis on inherited assets, which can negate thousands of dollars in capital gains tax for certain taxpayers. Congressional members and presidential candidates alike have expressed dislike for the rule, and change may be on the horizon.