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The KRASA LAW, Inc. Estate Planning Blog

Friday, March 29, 2019

Step-up or Step-down?

When certain “capital assets,” such as real property or securities, are sold, capital gains tax will typically be due on the difference between the “basis” in the property and the sales price. The “basis” in an asset is the original purchase price. With regard to real property, the basis can be adjusted by the cost of improvements on the property (i.e., installing a new roof). The higher the basis, the less the gain, and the less the tax. Conversely, the lower the basis, the higher the gain, and the higher the tax. As a result, taxpayers want the highest basis possible. 

Combined federal and California capital gains tax on the difference between the basis and the sales price ranges between 25% to 33%. If the asset was used as a personal residence by the seller for two of the previous five years, the first $250,000 of gain will likely be exempt from capital gains tax but any additional gain would be subject to the tax. 

For example, assume that you purchased a rental property forty years ago for $200,000. Over the years, you invested a total of $100,000 in improvements to the house. Your basis is currently $300,000. Assume that today, the house is worth $1,000,000. If you were to sell the house, you would recognize a “gain” of $700,000.

If you transfer the property during life, the recipient of your gift will “inherit” your basis of $300,000. If the recipient of your lifetime gift sells the house for $1,000,000, the recipient will also recognize a gain of $700,000.

Upon your death, the basis in your property will be adjusted to the fair market value on the date of your death. For example, assume that the basis in your rental property is $300,000 but it was worth $1,000,000 on the date of your death. The basis in the property for your heir will be readjusted to $1,000,000. If your heir sells the property for $1,000,000, the heir will have no capital gains tax at all. If the heir waits three years to sell the property when it is worth $1,200,000, the heir will only have to recognize a gain of $200,000. 

This basis adjustment to the fair market value as of the date of a property owner’s death is often referred to as a “step-up” in basis. The term assumes that the asset will be worth more upon the death of the property owner than the property owner’s basis. While it is often the case that real property and investments increase in value over time, that is not necessarily the case. If the fair market value of an asset is worth less than the basis as of the date of the property owner’s death, then there will actually be a “step-down” in basis. 

For example, assume that you purchased a rental house at the height of the market for $1,000,000. However, the market declined and today it is worth $800,000. If you were to sell the house for $800,000, you would have a $200,000 loss. But assume that you held it until you died when it was worth $800,000. Your heir’s basis in the property would be $800,000. If the heir sold it a year after your death when it appreciated in value to $900,000, your heir would have to pay capital gains tax on the $100,000 gain, despite the fact that your basis was $1,000,000. 

It is important to understand the other side of the basis adjustment rule: capital assets do not always appreciate in value. While the readjustment in basis to the value of the property as of the property owner’s date of death is an advantage for the heirs when the rule results in a “step-up” in basis, it might be detrimental to the heir if the rule results in a “step-down” in basis. 

KRASA LAW, INC. is located at 704-D Forest Avenue, Pacific Grove, California 93950 and Kyle may be reached at 831-920-0205. 

Disclaimer: This article is for general information only. Reading this article does not establish an attorney-client relationship. Before acting on any of the information provided in this article, you should consult a competent attorney who is licensed to practice law in your community. 


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KRASA LAW assists clients with Estate Planning, Elder Law, Pet Trusts, Asset Protection, Special Needs Planning and Probate / Estate Administration in Pacific Grove, CA(93950), Monterey (93944, 93940, 93943, 93942), Salinas (93901, 93905, 93906, 93907), Hollister (95023,95023) Pebble Beach (93953), Carmel By The Sea (93921), Seaside (93955) and Carmel (93923, 93922) in Monterey County and San Benito California.

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