How the Stepped-Up Basis Loophole Works

How the Stepped-Up Basis Loophole Works explained by professional Forex trading experts the “ForexSQ” FX trading team.

How the Stepped-Up Basis Loophole Works

Every long-term investor needs to know about something called the stepped-up basis loophole (also sometimes called the stepped-up cost basis loophole). It’s a tax benefit Congress gives families who aren’t rich enough to be subject to the estate tax but who diligently built wealth by acquiring stocks, real estate investments, or other property (such as construction equipment) throughout their lifetime and want to pass that money on to their children, grandchildren, nieces, nephews, or other heirs.

Managed correctly, the stepped-up basis loophole is an ace up your capital accumulation sleeve. I’d go so far as to say it’s a close second to the twin combination of a Roth 401(k) and a Roth IRA in terms of amassing money in the most tax-efficient way within a family tree when you’re taking a multi-generational approach. Under certain circumstances, it can even be preferable to an inherited IRA.

What is the stepped-up basis loophole? Under present tax law in the United States, when you die, the qualified stocks, real estate, and other capital assets that you leave to your heirs gets its original cost basis wiped out entirely. Your heirs get to pretend like they bought the stock or property at the fair market value on the date they inherited the asset. This can be an enormous advantage – it’s really hard to overstate if you understand the numbers – for long-term, buy-and-hold investors who, by their very nature, are likely to build up jaw-dropping deferred tax liabilities that let them grow their net worth faster than would otherwise be possible because they understand the frictional expenses of “switching costs”.

An Example of How the Stepped-Up Basis Loophole Might Look in the Real World

Imagine you are reasonably successful. Like 1 out of 5 families in the United States, you earn a minimum of $8,333 per month. You live below your means. Also, you are similar to a majority of American families in that you don’t have credit card debt or student loans.

We’ll assume you aren’t like the 1 out of 3 homeowners who have no mortgage, but, instead had to finance the purchase of your home so there are some regular payments involved but they are modest because you are conservative with your money. You plan on paying that off before you retire, though, so it doesn’t cause you to lose sleep at night.

You decide that you are going to save 1/10th of your starting pre-tax income in a regular brokerage account or through direct stock purchase plans and their closely related sibling, DRIPs. You invest in a basket of stocks that compounds at average rates of return. (For the sake of simplicity, we’ll assume you only bought non-dividend-paying stocks as it will keep the illustration straight-forward but the underlying concept is the same regardless). You keep this up for 35 years. You never increase your annual savings by inflation so it represents a smaller and smaller burden on your cash flow as time passes and the dollar loses purchasing power.

Over the years, you put aside $350,000 out of your own pocket. You end up with $2,710,244 sitting in your brokerage account. This represents an unrealized gain of $2,360,244.

If you sell the stock, under the present tax rules, you are going to have to pay roughly:

$472,049 in Federal capital gains taxes
$89,689 in Obamacare taxes
Between $0 and $251,800 in State and local taxes depending on where you live

Under a worst-case scenario (e.g., you live in Southern California or New York City), you’d be lucky to end up with $1,896,706, of which $350,000 represented your original principal and $1,546,706 represented your nominal after-tax profit before inflation adjustment. You gift the money to your heirs in your will or through a trust fund and that is that. If your heirs turn around and invest the money in an asset that also earns average rates of return, they might enjoy an $189,671 annual increase in personal net worth from the wealth producing more wealth.

If instead, you qualify to take advantage of the stepped-up basis loophole without triggering the estate tax, you could pass the entire $2,710,244 to your heirs without the Federal, State, or local governments getting anything!

All you have to do is leave the appreciated shares of stock, real estate property, or other capital assets to your heirs. When you die, the fair market value will be appraised (in the case of stock, this is often easy as it is the market quotation) and the heirs get to pretend like that price – the inherited price – is their cost basis.

This stepped-up basis loophole gives you heirs two superior alternatives.

If they hold onto the stock or real estate and it continues to produce average rates of return, they are earning it on the higher asset level of $2,710,244, not the lower $1,896,706. This means they’d enjoy an increase in wealth of $271,024 per year, not $189,671. That is an extra $81,353 per annum or 42.89%. Meanwhile, the $813,538 in additional equity sitting on their balance sheet can lower their cost of borrowing elsewhere or serve as collateral if they want to fund a new acquisition or development (something that is particularly important in savvy real estate families prone to picking up apartment or office buildings as an on-going activity with the expectation that each generation will grow wealthier than the last).
If they sell the stock, real estate, or other asset, they can pocket the entire $2,710,244. That is an extra $813,538 in real, cold, hard, liquid cash that would have gone to politicians but now is available for those about whom you care to use for the purpose of building a better life for themselves; putting their own kids through college, traveling the world, building their dream house, buying a new car, and paying medical expenses without the stress of financial worry being just a few options.

Using §2032 Elections for Alternative Valuation to Maximize the Benefits of the Stepped-Up Basis Loophole

If that weren’t good enough, Congress offers an additional sweetener. In all years except 2010 (there were some weird things going on with the tax code at the time that involved something known as a “modified carryover basis” with certain spousal and non-spousal limits), heirs can opt to take advantage of an alternative valuation date that is no later than six months from the date of death. If an asset has appreciated significantly, this is a fantastic advantage as it allows an even higher cost basis to be enjoyed, lowering future taxes even more.

If You Give Stock or Property as a Gift While You’re Still Alive, You Will Lose the Stepped-Up Basis Loophole Advantage (But It Can Still Be a Good Idea)

What happens if you want to give your heirs shares of appreciated stock or other property during your lifetime? They won’t get to take advantage of the stepped-up basis loophole. Rather, they’ll inherit your cost basis as if it were their own; as if they, themselves, had been the original purchaser on the same terms, at the same price, and same date that you did. That means it’s almost always a better idea to give cash or freshly purchased shares (where the market value and cost basis are comparable), instead, keeping the appreciated stock until death.

There is one major exception to this rule: If you are going to go over the estate tax limits, and you don’t have a lot of cash on hand, you can use the annual gift tax limit exclusions (currently $14,000 per person, per year) to give appreciated stock, real estate, or assets to your heirs to lower the size of your estate, saving tremendously on the taxes that would otherwise be owed. There are even advanced techniques that have been given the green light by the tax court involving the use of a family limited partnership to transfer a lot more money thanks to something known as a liquidity discount (do not attempt this without consulting with a qualified tax specialist).

Picture this scenario: You are like Ronald Read, the janitor who recently passed away. He left behind an estate valued at more than $8,000,000 despite earning close to minimum wage for most of his life. It resulted from his habit of living below his means then investing the surplus money in good, dividend-paying stocks. (Even from small beginnings, a 60-year stretch of time can work wonders when it comes to building wealth!)

Let’s assume you have 4 children and are married. You and your husband or wife could gift $14,000 each to everyone one of the four kids ($28,000 total to each of them once you combine annual exclusions). That’s $112,000 given away, no longer subject to estate taxes. As long as your children continue to hold the stock, they enjoy any appreciation as ownership has now shifted to them. That appreciation isn’t part of your estate, effectively meaning you’ve dodged other taxes that would have been levied on top of the estate tax on the gift itself. The numbers can get really crazy if you continue down the family tree. Imagine each of your kids had 3 children of their own. That’s 12 grandchildren. Between you and your spouse, you could give away an additional $336,000 tax-free per year, on top of the $112,000, for a total of $448,000. Do that for 10, 20, 30+ years and all but the richest families in the world can effectively migrate their holdings from one generation to another, side-stepping an IRS bill. Make sure the final appreciated property is below the estate tax limits and the rest of it gets inherited with the stepped-up basis loophole.