What Is the Stepped-Up Basis Loophole?

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The stepped-up basis loophole is a method for bypassing capital gains taxes when an asset is passed on. This tax loophole adjusts the tax value of an asset so that if it has appreciated in value and is sold, there are less capital gains to be taxed.

Learn more about the stepped-up basis loophole, how it can help you pass more of your wealth to your heirs and how it is used by the ultra-wealthy to concentrate their wealth.

Definition and Examples of the Stepped-Up Basis Loophole

Tax laws in the United States allow qualified stocks, real estate and other appreciable assets you leave to your heirs to have their original cost basis adjusted. This adjustment lowers capital gains taxes if the asset is sold after it is passed on.

Basis is the amount you paid for an asset. If you pass it on to an heir, they can sell it. If they sell it for more than you paid for it, they made a profit, and capital gains taxes are triggered.

Step up in basis considers the asset's fair market value if your heir was to purchase it today. That way, if they sell it capital gains taxes are either significantly reduced or avoided.

A capital gain is a profit made from the sale of an asset due to an increase in its value over time.

Alternate name: stepped-up cost-basis loophole

How Does the Stepped-Up Basis Loophole Work?

The stepped-up basis loophole impacts how and when you decide to pass your accumulated wealth on to your heirs. If you wait until after your death, the loophole allows them to realize more capital gains with fewer taxes.

For instance, if you purchased a house in 1981 for $100,000 and kept it in excellent condition, it could now be worth nearly $300,000 based on inflation alone. If it has appreciated, it might have a fair market value of $350,000.

If your child receives the property through your will and sells it for $400,000, there would be a profit of $300,000 if not adjusted for inflation or current market value.

After the step-up in basis, there would have only been $50,000 made on the sale, significantly reducing the amount of profit, and therefore capital gains taxes.

If you give your heirs shares of appreciated stock or other property while you're alive, they'll inherit your cost basis as if they had been the original purchaser. Give cash or freshly purchased shares during your lifetime, keeping the appreciated stock until you are no longer alive.

Investments work the same way if you pass them on to your heirs. If you invested $250,000 over your lifetime and end up with $2,710,244 in your brokerage account, you'd have an unrealized gain of $2,460,244.

If you sell the stock, you'll have to pay federal capital gains taxes as well as state and local taxes. At the 20% tax rate, this could leave you with $1,968,195 for your heirs—$350,000 of which is the original inflation-adjusted principal. There would be $1,618,195 profit left after taxes. 

If you qualify to take advantage of the stepped-up basis loophole without triggering estate taxes, you could pass the entire $2,710,244 to your heirs. The amount would be the fair market value because it is the current value of the investments, and the heirs would get that amount as their new cost basis.

This stepped-up-basis loophole gives your heirs two options for handling their inheritance:

  • Hold onto the assets: With the new and higher cost basis, they would earn returns on the higher asset level of $2,710,244, not the lower $1,968,195. 
  • Sell the assets immediately: They can pocket the entire $2,710,244, saving them $842,049 that would have been paid in taxes if not for the loophole.

Limitations of the Stepped-Up in Basis Loophole

The stepped-up cost basis won't benefit your heirs if you will exceed the estate tax limits and don't have a lot of cash on hand. In that case, you can use the annual gift tax limit exclusions to give appreciated stock, real estate, or assets to your heirs while you are still alive.

The stepped-up basis loophole competes with the Roth 401(k) and a Roth IRA in terms of amassing money in the most tax-efficient way for generations of your family.

That approach will help you lower the size of your estate and save on the taxes that you'd otherwise owe. If you make sure the final appreciated property is below the estate tax limits, then the rest of it gets inherited with the stepped-up basis loophole.

Be sure to consult with a qualified tax specialist before taking these steps to ensure you're doing it correctly.

Alternatives to the Step-Up in Basis

A report issued by the Joint Committee on Taxation in 2018 found that switching to a carryover basis, rather than a stepped-up basis, for inherited assets would increase federal revenue and lower the deficit by $105 billion from 2019 to 2028.

Another advantage to switching carryover basis would be to encourage owners to put their assets to more productive uses throughout their lifetimes rather than simply holding onto wealth. This could include starting or otherwise funding new businesses or investing in local communities and charities.

Criticism of the Step-Up in Basis Loophole

While this tax-sheltering technique is beneficial for investors who have spent their lives saving and working to build wealth for themselves and their families, the stepped-up basis means that people generating large amounts of income from capital gains are unlikely to pay taxes on them.

The loophole encourages investors to hold on to their assets. If investors were to sell their assets, pay taxes on the gains or spend the profits, it would give the economy that much more of a boost and help to deconcentrate much of the wealth.

Step-up in basis has become another tool used by ultra-wealthy, high-earning households to pass on their wealth and bypass taxes that many other investors and savers pay. The majority of realized capital gains in the United States already go to households with the highest income. In 2018, the top 1% of households (ranked by income) realized 69% of capital gains but do not pay taxes on them.

Key Takeaways

  • The stepped-up-basis loophole allows the basis of an inherited asset to be stepped up to its value at the time of the original owner's death, which reduces any potential capital gains taxes owed by the person who inherits it.
  • It is one of the most tax-efficient ways to accumulate and pass on money for generations of your family. 
  • The stepped-up-basis loophole has been criticized for contributing to the concentration of wealth in already high-earning households, reducing tax revenue, and encouraging tax shelters rather than economic participation.