A primer on basis step up and estate planning:
When you sell an item of property, you generally pay tax on the capital gains. This tax is applied to the excess of the sale price over your tax basis in the property. Your basis is generally the purchase price, perhaps augmented by the cost of improvements made.
If you were to give away that property during life, the recipient would generally take your tax basis in the property and use it to calculate any gain from a sale by the recipient.
However, under 26 USC § 1014(a), the basis of property acquired from a decedent is adjusted to fair market value (FMV) on the date of death (or on the alternate valuation date, six months later). Generally, it is said to receive a “step-up” in basis because values tend to rise, although recent experience has reminded us that “step-down” is also a possibility.
Assets acquired from a decedent include assets in a testamentary trust, a grantor trust, or a revocable living trust.
Under 26 USC § 1014(b)(6), the surviving spouse’s one-half of any community property is also considered to be property acquired from a decedent, for purposes of basis step-up. [Under Rev Rul 87-98, 1987-2 Cum Bull 206, property held formally as joint tenants may be given full step-up if actually community property under the laws of the state in which it is held; if title is in a common law jurisdiction, the resulting presumption that property is separate may be rebutted with evidence of intent that property was to remain as community property.]
Assets from the deceased spouse which fund a QTIP trust and thus qualify for the marital deduction and are includable in the taxable estate of the surviving spouse, are considered property of a decedent and given a step-up in basis at survivor’s death. 26 USC § 1014(b)(10).
Income in respect of decedent (IRD)—for example, promissory note, annuity, IRA—is not given any basis step-up. 26 USC § 1014(c).
Where property is highly appreciated and the owners have low life expectancy, it may be better to wait and let the property pass upon death in order to get the step-up, rather than gifting the property during life (limited partnership interests, for example) which results in only a carryover basis at best, and possibly not even that if basis at time of gift exceeds fair market value. 26 USC § 1016.
Loss of full step-up may result from using IRC §2032A to obtain a Special Use Valuation to avoid estate tax.
