#73: Understanding ‘Step-Up in Basis’ for Minimizing Taxes

In the pursuit of legally reducing lifetime tax payments, this episode unveils the strategic advantages of understanding step-up in basis and how it applies to various inherited assets. Chris succinctly breaks down the essence of cost basis and its implications for capital gains tax. His expertise shines through as he presents everyday scenarios, articulating a clear picture of the benefits and intricacies involved. 

Key Takeaways:

  • A ‘step-up in basis’ significantly reduces capital gains tax on inherited assets by adjusting the asset’s cost basis to its market value at the time of inheritance.
  • Inherited assets are automatically treated as long-term capital gains, beneficial for lower tax rates, regardless of how long the asset was held prior to sale.
  • Beneficiaries should not rely on old brokerage statements for cost basis and must ensure their inherited assets’ cost basis is updated correctly.
  • In community property states, surviving spouses may benefit from a “double step up in basis,” further reducing potential tax liabilities.
  • Consulting with a tax professional is crucial when dealing with inherited property to ensure proper tax treatment and maximization of available deductions.

Notable Quotes:

  • “It’s much better to inherit assets than to receive them as a gift.”
  • “Any inherited assets are automatically considered long-term capital gains, which we know are the lower rates.”
  • “Make sure that you, what we call, review your depreciation schedules or realistically have your tax professional review your depreciation schedules because you might not know what the heck you’re looking at.”
  • “A lot of the things we talk about here on the podcast is really based around tax planning and strategy.”

Resources:

  • Defeating Taxes Facebook Group: Search “Defeating Taxes” on Facebook to find and join the private group discussed in the episode.

Dive into the full episode for an in-depth exploration of ‘step up in basis’ and gain valuable insights into how it can benefit your tax strategy. Stay tuned for more episodes from “Teaching Tax Flow” to continue enhancing your tax knowledge and uncover constructive financial tips.

Episode Sponsor: The Mortgage Shop

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Welcome to the Teaching Tax Flow podcast, where the goal is to empower and educate you to legally and ethically minimize taxes paid over your lifetime.

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Hey, everybody, and welcome back to Teaching Tax Flow, the podcast today, episode 73. We are gonna step up our game and talk about the step up in basis, what that means if you even care at all about taxes, and we know you do because you’re here. Before we get into the topic, though, let’s take a brief moment as always and thank our sponsor on this episode.

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This podcast is sponsored by The Mortgage Shop. Are you looking to qualify for an investment credit loan without jumping through hoops? That’s easy. They have loans with LTV up to 89.99%. Exploring their products and discovering how they can work for you is simple. Just visit mortgage.shop or call 865325256 6, and tell them TTF sent you.

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Welcome. Welcome. Welcome back to the Teaching Tax Flow podcast. Hopefully, you listened to the intro. If not, we know you’re anxious.

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You jump right into it. Today, step up in basis is on the table. And Chris is back with us. Chris Picciurro, how are you, man?

00:01:20.165 –> 00:01:23.305
Oh, it’s so good to be back, Johnny t. How are you, my friend?

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Oh, it’s Michigan. It’s chilly, but it’s all good, man. It’s all good. Let’s warm up the plates and talk about what in the world is step up in basis. And, actually, here’s a little disclaimer on my end.

00:01:34.500 –> 00:01:47.270
Right? Everybody knows I am not the tax guy. You are the tax guy. I am really not sure a 100% what this topic even is. So give us your, well, call

00:01:47.270 –> 00:02:18.520
it knowledge nugget, I guess, on what step up in tax basis actually is. This is a confusing topic for many, so even some tax professionals, and it’s a topic that causes people sometimes to pay too much in tax. So we’re gonna keep things as as, elementary as possible, because this is this is a confusing topic, like I said. So here’s the situation. Let’s start with basis, Okay.

00:02:18.520 –> 00:02:36.010
First of all, before we talk about step up in basis. Basis is a term that we use in tax, and it’s short for cost basis. So really easy example, John. Let’s say that you bought some, a share of of Bitcoin

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Okay. Okay.

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Or 1 Bitcoin for $30,000 and you go and sell it for $60,000, okay, your cost basis for that Bitcoin is $30,000. You sold it for $60,000. So to determine what your capital gain is, so how much you pay tax on, you take the 60,000 minus your cost basis of 30,000. Then, obviously, if it’s a long term gain long term gain or short term gain, it’s taxed differently. That’s the most simplistic tax basis that we can come up with.

00:03:13.710 –> 00:03:43.320
Alright? So a step up in basis is a special rule in the tax code that allows people to adjust their tax basis for any asset that they inherited. So you’re gonna hear a lot of times people say, well, it’s much better to inherit assets than than to receive them as a gift. Now I’m gonna talk about that, you know, in our example. So everyone take a breath, understand we’re gonna go through a real life example.

00:03:43.940 –> 00:04:24.285
Names have been hidden, but to really explain the step up in cost basis. So the bottom line is when you inherit an asset, now that asset could be that that that cryptocurrency, it could be a home, it could be a stock, It could be a piece of artwork. Any asset. When you inherit that asset, your cost basis, meaning what you’ve what the IRS is looking at or what you’ve paid for that is whatever the fair market value is at the time someone passed away. And so there’s an adjustment.

00:04:24.985 –> 00:04:41.825
So for someone inhering an asset from what we call a decedent, usually, it’s either could be through a a just a will, a probate case, or a trust. The tax basis of the asset gets stepped up to fair market value.

00:04:41.825 –> 00:04:59.135
So I know on this, if anybody’s a fan of those true crime podcasts and you talk about, you know, hey. You’re better to inherit than better to, be gifted. We are not implying you should go out and start, you know, whacking your in laws or anything. So this is not a murder. No.

00:04:59.135 –> 00:04:59.375
That

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that that’s not a it’s

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not a a murder investor. Whatever. You get you get where I’m going with this. Let’s get back on topic. So, yeah, walk us through this.

00:05:08.290 –> 00:05:25.125
I’m super curious. I’m, like, super curious on how this works because, right, this is something that I’m gonna make the assumption a lot of people don’t even know exists. Right? And and they just kind of assume that things are gonna happen. So this, I think, will lay level the playing field with a lot of concerns, I should say.

00:05:26.405 –> 00:05:58.475
Absolutely. Because a lot of tax software, even if you’re a self preparer or if you’re someone that prepares taxes professionally, even those, a lot of times, those softwares don’t trigger to figure out what a you know, if the asset’s been stepped up. So there are 3 real big benefits of a step up in basis, and there’s a reason. Remember, one of the three laws of teaching tax flow is that tax laws are written to encourage or discourage certain behavior, so we want to inherit assets. We also know that the IRS wants some type of simplicity.

00:05:58.475 –> 00:06:19.295
Now if you’re snickering when you hear that, we understand, but let me explain. So there’s 3 main benefits of a step up in basis. The first one is a reduced capital gain. Right? So, John, let’s let’s say you had that that that share of Bitcoin, you paid 6 $30,000, it’s worth 60,000, you you, get hit by a beer truck.

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You know you know how that’s how I like to knock people out. Right? And, your daughter inherits it. Okay? Some reason Stacy doesn’t inherit it.

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Let just go with it. Your daughter inherits it. She sells it the next day for $60,100. Okay? She gets her cost basis is 60,000 because that’s what it was worth when you got hit by the beer truck.

00:06:45.680 –> 00:07:14.955
She only pays tax on a $100, thus reduced capital gain. She sells it for $60,100. Her even though you paid 30, her basis is 60. So a reduced capital gain calculation is huge, and this is something that people don’t know that, about. Any inherited assets are automatically considered long term capital gains, which we know are the lower rates.

00:07:15.170 –> 00:07:33.800
So you even if you inherited asset, you don’t have to keep it for a year to get the long term capital gain treatment. So one is reduced capital gain. Number 2 really plays a role when we’re talking about real estate or any type of, like, business equipment. The avoidance of depreciation recapture. Oh my gosh.

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What’s depreciation recapture? Should we do another episode on that? We probably should. Here’s what depreciation recapture is. If you have an asset let’s use a easy example.

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Let’s say you bought a rental property for $275,000 and there is no land allocation, so exactly $10,000 depreciation every year. Let’s say you own that property. You bought it for 2.75. You owned it for 10 years. You took a $100,000 of depreciation deduction.

00:08:02.075 –> 00:08:18.615
Right? So you’ve written that deducted that on your tax return. When you sell the property, you have to recapture or take that $100,000 of depreciation deduction and put it onto your tax return. That’s depreciation recapture. So let’s say, John, you bought the property for $275,000.

00:08:20.195 –> 00:08:34.615
You owned it for 30 years. You wrote the entire $275,000 off over your lifetime. You get smacked by a beer truck. John, I know you like you know, you like some darker beer, so let’s what kind of beer truck would you want to take you out?

00:08:34.615 –> 00:08:44.690
Oh, man. Let’s, let’s say there’s a Guinness rig just rolling through town. You know, if you’re gonna you know, if you’re but if I’m gonna go out by getting hit by a I mean,

00:08:44.690 –> 00:08:47.170
maybe be like a a Patron truck or something.

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You know? Try to get real fancy and real real. A little bit, Whatever. We’ll go

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next again. Before we go ground. We’ll go

00:08:53.185 –> 00:09:06.965
for weeks. And, actually, before we jump into this example too. So really quick. One thing, you know, we mentioned before is, you know, that we mentioned long term capital gains. And if I’m understanding this still correctly, right, long term capital gains comes into effect after 1 year of owning an asset.

00:09:06.965 –> 00:09:07.285
Correct?

00:09:07.285 –> 00:09:08.645
Short term for bringing that up.

00:09:08.725 –> 00:09:10.725
Is 0 0 to 1 year. Correct?

00:09:10.725 –> 00:09:28.555
Correct. After 1 year, an asset gets long term capital gain treatment, which in general is about half of the tax rate that you would pay otherwise in general. There’s a lot of rules with it. Well, the cool thing is, let’s say you bought that property, owned it for 30 years, you depreciated the entire amount, John. You greedy pig.

00:09:28.555 –> 00:09:41.495
You wrote off all $275,000. You get smacked by a Guinness truck, and, you know, your daughter inherits the property. Good for her. Bad that you’re gone. I appreciate that.

00:09:41.635 –> 00:09:47.095
Yeah. The property now is worth $500,000. Hey. Good job, John. You made a good investment.

00:09:47.555 –> 00:10:19.635
Guess what? 1, your daughter gets a basis of $500,000 and she gets started if she keeps this as a rental property. She can start depreciating it all over again at 500,000, and she does not owe a penny of depreciation recapture on the $275,000 that you wrote off over your lifetime. So the avoidance of depreciation recapture is a the second big benefit. The third is and this is kind of a dual benefit with the IRS, it’s a simplification of tax calculation.

00:10:20.575 –> 00:10:45.240
How do you know how difficult it would be to figure out what someone’s cost basis is if someone passed away and they bought something years years years ago? Now rental property, you usually have a depreciation schedule on your tax return, but, John, I know I mean, real life examples, both of our grandparents, back in the day, bought stock, like stock certificates. Right? Yes. It is.

00:10:45.300 –> 00:10:59.170
Bonds, but mostly stock certificates. And a lot of times those stocks certificates, it’s hard to determine how much they paid for them. They weren’t they’re just sitting in in a safety deposit box somewhere. Right? Or think about the example, John.

00:10:59.170 –> 00:11:24.660
Let’s say you bought a mutual fund and you owned it for 20 years. And every year, that mutual fund paid a little bit of dividends and you just reinvested that dividend back in to the mutual fund. It’s very challenging to figure out what your cost basis is. So the simplification of a tax calculation, not having to worry about what your the the decedent’s cost basis was is the third benefit of a step up in tax basis.

00:11:25.395 –> 00:11:31.930
And really everything that we’ve talked about here. I mean, and to be totally honest, right? Again, this is coming from somebody who,

00:11:32.890 –> 00:11:34.490
again, in all transparency, didn’t know

00:11:34.490 –> 00:12:01.955
a lot about this before me and you were literally talking about this right now. This really seems like this may be one of the we’ll call it an Easter egg or a surprise or whatever the heck we wanna call this thing, where the IRS is they could have made this a lot more or I should say a lot less beneficial to the taxpayer. This is something I think that holds so much weight. And it’s almost a yeah. Know, we should be thanking them in a sense for for doing this because they really don’t have to in a sense.

00:12:01.955 –> 00:12:05.120
Right? And oh, no. Go ahead. Right.

00:12:05.120 –> 00:12:08.560
No. I’m sorry. I I I’m good at interrupting you, so I’ll do it again. No. No.

00:12:08.560 –> 00:12:36.345
You’re right. The the IRS, it is simplification for them and us now, but spoiler alert, we’re gonna do some deep dives later this year into the presidential candidate’s tax plans. And there are some tax plans out there that wanna eliminate the step up in basis in in which there’s some just like many tax laws, there a lot of times there’s unintended consequences. Right? But you’re right.

00:12:36.345 –> 00:12:40.620
It is a simplification. And so the it does help the IRS

00:12:40.620 –> 00:12:53.955
a bit too. And let me let me ask you this actually too. So this is, you know, kind of you getting back into your your private practice a little bit. So first question, how long has this actually been around for? Is this is this something that’s new?

00:12:53.955 –> 00:13:27.195
Is this something that’s probably been around for a long time? And if you know, you probably don’t even know that because it’s probably, you know, it’s one of those things. It’s just here now, it’s important, we focus on it. But more importantly, how many times thinking, you know, again, in your private practice, people that have say it’s come, you know, quote unquote tax time or they’ve inherited something and they don’t know this exists. And maybe they, you know, were with a a previous account before CPA, done all has done all their preparing and you look at it and say, well, what did you do with this, you know, 2, 3, 4 years ago?

00:13:28.055 –> 00:13:42.835
Can you go back or did you or can you or should you go back and adjust for this? Or is this something that you kind of have to jump on right away? Like, if we look at, you know, a 1031 exchange, it’s not something that you can, oh, crap. You know, I missed the window. I can’t go back.

00:13:42.835 –> 00:13:44.295
How does it look in this case?

00:13:45.235 –> 00:14:06.415
Well, this has been around for at least 25 years. I don’t know when exactly it started, but I or at least as as long as yeah. As I’ve been as I have been practicing. You nailed it. I can’t tell you how many times we identify an error on a tax return that’s a pro tax payer.

00:14:06.635 –> 00:14:26.010
So I’ll give you. And, yes, you can amend your return in many cases. Or in some cases, when it comes down to real estate, you can make an adjustment to your depreciation schedule using what’s called a 481 a adjustment. I I don’t wanna get too technical. So let’s let’s think about practical takeaways for our listeners.

00:14:28.070 –> 00:15:14.995
The first thing is when you inherit property, especially stocks, mutual funds, etcetera, etcetera, don’t take the cost basis on the brokerage statements as gospel because sometimes those brokerage statements have the original cost basis before you inherited the property, and it’s it might report I mean, with with, you know, a a cost basis that’s much lower than what the cost basis really is when you inherited a stock. So let’s say let’s say, John, you inherited a stock, that was worth $1,5000 when you inherited it. Let’s say your parents bought it for 2,000 and you just took over you know, the you transferred that stock into another statement for you. Right? They you were the beneficiary of their brokerage account.

00:15:15.810 –> 00:16:08.090
Not all brokerages will adjust the cost basis up to the new owner’s cost basis. So you go and sell it, and it looks like you made 3 grand, but really you didn’t. So my my point is if you are listening to this and you have inherited assets, especially in a brokerage account, let’s start there, make sure you talk to your tax professional and your financial adviser to ensure that the proper cost basis is being reported on those statements and that if you sell it and it’s inherited, it’s coded as a long term capital gain. Now if you own real estate, this is where it gets really, really interesting. If you own real estate that you inherited, make sure that you started your depreciation schedule, meaning when you’re going to deduct it from the day you inherited it.

00:16:08.710 –> 00:16:25.090
One more huge tidbit. If you live in a community property state, there’s a chance that you can get what’s called a double step up in basis. So let me walk you through I said I’m gonna have a real life example. Let me walk you through an example. Okay?

00:16:25.710 –> 00:16:35.710
John, let’s go back. Let’s say that you bought a property. Let’s say you and your lovely wife bought this $275,000 property, no land allocation. We want easy math. Right?

00:16:35.950 –> 00:16:48.905
And you get a $10,000 depreciation deduction every year for that property. Okay? You guys own it jointly. You get hit by a beer truck. Your wife survives.

00:16:49.445 –> 00:17:11.690
Alright? And you’ve you’ve owned it for 10 years. Well, what would happen is she actually inherits half of the property and she should step up half your half on the tax return and reset your depreciation schedule, which is huge. She’s gonna get a lot more deductions. She keeps her half of the depreciation schedule on the same.

00:17:13.270 –> 00:17:30.330
But let’s say you live in Texas, a community property state. You get smacked by a herd of cattle or an exotic animal down at our friends at wildlife partners. Right? You get you you you were knuckleheading around, you jump a couple of fences, and you get trampled. What what would trample you over there?

00:17:30.330 –> 00:17:32.170
I’m trying to remember some of those things, man.

00:17:32.170 –> 00:17:40.505
Pretty much every one of their every one of them out of there is bigger and faster than me. So pretty much every one of them I could find a way to, you know, stir the pot.

00:17:40.505 –> 00:18:29.850
And you get, yeah, you get you get trampled. And, but in Texas, right, since it’s a community property state, there’s a good chance that she gets a she gets to step up the basis of a 100% of the asset, meaning she gets to start fresh and redepreciate that property, and let’s say that property that you bought for 2.70 is worth 500 now, guess what? You get to start fresh. $500,000, you start reset your depreciation schedule. So the point is, if you own any type of rental property and you are a widow or you have inherited it, make sure make sure that you, what we call, review your depreciation schedules or realistically have your tax professional review your depreciation schedules because you might not know what the heck you’re looking at.

00:18:30.470 –> 00:18:44.330
In the state of Tennessee, and this comes down to estate planning also. So please reach out to our community. You know, jump into our defeating taxes private group. John’s gonna slap me for mentioning it during the show, but I’m gonna do it anyway. There’s a slap.

00:18:44.530 –> 00:19:09.095
Some questions. So really focus because, like, in the state of Tennessee, we’re not a community property state, but we have a special trust here that gives people a double step up in basis even if they’re not a resident here. So there’s some really great estate planning opportunities for people as well. So that’s why, you know, people think step up in basis. I haven’t inherited anything.

00:19:09.475 –> 00:19:41.857
Well, guess what? If you’re a widow, you might have you might have a step up in basis and you could legally and ethically reduce your tax you paid in your lifetime with no out of pocket cash. So at least once a month, John, someone in the teaching tax law community comes to us with a lot of times they’ll come to us with a question. They might be doing, John, you know, I do a lot of 1 on 1 tax coaching and tax their personalized tax plans, And sometimes they’re asking me questions about something like retirement or stuff like that, and I’m looking at the depreciation schedule. I’m saying, oh my gosh, guys.

00:19:41.857 –> 00:19:49.780
We we have a ton of deductions sitting on the books that you don’t know about. And that’s actually a great kind of wrap up on things too, Chris. And and

00:19:49.780 –> 00:19:55.825
do you know what make you feel better, man? You know, being in Michigan still, I don’t think I don’t think we’re a community property state, are we?

00:19:56.045 –> 00:20:17.885
No. I’ve been doing some due diligence, so there’s some opportunities for people to potentially create a trust in a community property state even if we don’t live in 1 and get the double double step up of basis. So just reach out to us, jump in our community. You know? Find and, John, can we wrap on one really I know I used some examples with depreciation and rental properties.

00:20:18.105 –> 00:20:36.435
Let’s use a super easy inheritance situation, okay, to wrap on. So let’s say you’ve got let’s say you’ve got Cindy. Cindy inherits a piece of property from her grandmother. Right? Grandmother bought it’s just land so we’re not dealing with depreciation.

00:20:37.615 –> 00:21:03.395
Cindy’s grandma bought a plot of land for $50 because her grandma was gonna build a house on it, but grandma never built the house on it. Grandma passes away. Cindy inherits the land. Now the land’s worth $300,000 Cindy could then go sell the land for, let’s say, for $300,000. She doesn’t pay tax on that $250,000 of gain.

00:21:03.955 –> 00:21:28.640
And even if Cindy only owned the property for a month, it’s still long term capital gain if she has a gain, or she could have a capital loss if something went down after she inherited it. So That’s a great example. Very cut and dry for the most part. So I think that’s one, you know, that that we can relate to. And, really, Chris, I think what’s super important about this

00:21:28.960 –> 00:21:50.710
this show, this topic is that, you know, what we talked about is not a theoretical thing, right? Like 1 in a 1000000, this might happen to a lot of people in here, different things. Right? So I could see this being super beneficial, say to somebody who’s younger, maybe they just have been DIYing their tax prep every year. That’s great.

00:21:50.710 –> 00:22:01.775
Maybe work for them. They inherit something. They don’t know this exists. The software probably doesn’t know this exists. Maybe even their tax professional they’re working with doesn’t know that this exists.

00:22:03.310 –> 00:22:15.035
But super important. Right? Because this could literally I mean, sure. In inheritance is just that. It’s it’s great that you’re inheriting something, but the likelihood that you’re inheriting it because of a bad situation is very high.

00:22:15.095 –> 00:22:28.895
So make it a little bit better. But definitely tackle Chris, what you said there too. If any of those questions, defeating taxes is the place, defeating taxes.com, go to that. Drives you directly to the private Facebook group. We make it short and easy for you.

00:22:28.895 –> 00:22:39.960
We are very efficient around here, so we make it easy. That’s your private invite. If you don’t join, well, then, you know, it’s on you. Shame on you. And, you know, we’re not friends.

00:22:39.960 –> 00:23:03.185
But in all seriousness, thank you everybody for joining us back here. We will see you back here again as always, same time, same place next week. Hey everybody. John Topolsky here still from the teaching tax flow team. Couldn’t get rid of me that easy even though you probably tried, but I know this topic.

00:23:03.565 –> 00:23:27.940
Actually, I’m gonna say, well, over half of you probably didn’t even know that this exists. And let’s be honest, hopefully, you don’t need to, you know, know this for a little bit. But the important thing about this is exactly what I’m about to tell you. A lot of the things we talk about here on the podcast is really based around tax planning and strategy. If you’re not familiar with what that is, go back.

00:23:27.940 –> 00:24:04.025
We did a couple shows, I think, a little bit earlier on, a few months back. We really broke down the difference between the 2 and, really, on every show we do, I think a very important takeaway from this one as well specifically is just understanding that the relationship well, let’s be honest. The relationship you may have with your parents or your family member, your in laws, whoever you may be inheriting stuff from, you can control that a little bit. Maybe, maybe not. But the honest truth is you can actually control the relationship you have with the IRS by tax planning and strategy.

00:24:04.165 –> 00:24:14.290
So I’ll leave it at that. Won’t dive into that. Totally different topic, but everything we talk about here does relate to that. Little bits and pieces every week. We like to drip out bringing in guests.

00:24:14.290 –> 00:24:32.660
Obviously, Chris is welcome back here anytime considering that it is his show, but we look forward to all those questions that people in the community and the general public have. We love getting them. We love talking about them and we love discussing them amongst our team and our guests. So as always, thank you again for joining us here. We will see you very soon.

00:24:36.400 –> 00:24:53.960
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00:24:55.235 –> 00:25:05.349
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