by Lydia Jones
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Cost basis is a key concept in taxation that ultimately results in determining the amount of an asset’s value that is subject to tax. It is typically used to determine the gain or loss that an individual or entity realizes when they sell an asset, such as a piece of property or a holding in a brokerage account. The basis of an asset is typically calculated based on its original purchase price, including any associated costs like recording costs or realtor/brokerage fees. However, the basis of an asset can change over time due to various factors, such as depreciation or capital improvements.
One important concept related to basis is known as “step-up in basis.” This refers to a tax provision that allows heirs to adjust the basis of inherited assets to their fair market value at the time of the original owner’s death. This can be a significant benefit to heirs, as it can reduce the amount of capital gains taxes they may have to pay if they sell the inherited assets. It is important to note that since the valuation is at the fair market value, assets can also have a “step-down” in basis.
To better understand how step-up in basis works, it’s helpful to consider an example. Suppose that someone purchased a piece of property for $100,000 several years ago, and the property is now worth $300,000. If the owner were to sell the property, they would be subject to long-term capital gains tax on the $200,000 increase in value. However, if the owner were to pass away and leave the property to their heirs, the heirs would receive a step-up in basis to the fair market value of $300,000. This means that if the heirs were to sell the property for $300,000 shortly after death, they would not be subject to any capital gains taxes at all, since there would be no increase in value from the time they inherited it.
Step-up in basis only applies to assets that are inherited. If an asset is gifted during the original owner’s lifetime, the recipient’s basis is generally the same as the original owner’s basis. This means that if someone were to gift the above-mentioned property to their children, the children would inherit the original $100,000 basis, rather than receiving a step-up in basis to $300,000.
It is important to understand that there are certain exceptions to the step-up in basis rule. For example, if the inherited assets are held in an irrevocable trust, the step-up in basis may be limited or unavailable, depending on the specific circumstances. Additionally, certain types of assets, such as retirement accounts or annuities, are typically not be eligible for step-up in basis at all.
One way to make the process of dividing inherited items easier is to have a clear plan in place ahead of time. This can be accomplished by creating a will or trust that outlines who should receive your assets.
Calculating the basis of an inherited asset can be a bit complex, particularly if the asset has appreciated significantly in value over time. In order to determine the appropriate basis for inherited assets, it may be necessary to work with a tax professional. Please let us know if you need any assistance or have specific questions.
In conclusion, basis and step-up in basis are important concepts in taxation, particularly when it comes to inherited assets. Understanding how these concepts work can help you make more informed decisions when it comes to managing your finances and tax consequences.