Are We in Danger of Losing the Step Up in Basis?

           A few weeks back, President Obama proposed, in his State of the Union address, that the “step up in basis” provision of the capital gains tax be eliminated.  While Obama claims that he wants to eliminate a loophole for the rich, such a change could have a bigger impact on the average middle class American.

             But before I explain why, let’s first review what the step up in basis is exactly.  Certain assets, such as stock, mutual funds and real estate, appreciate in value over time.  I bought stock in ABC Company for $1.  If it is now worth $10 and I sell it, I have a gain of $9.  That gain is subject to something called capital gains tax.  The gain is calculated by subtracting the sale price minus the basis, which usually is the purchase price. (There are cases where the basis gets adjusted but we’ll keep our example simple.)

            There are certain instances where I may not have to pay capital gains tax.  One such instance is if I hold onto that stock and don’t sell it before I die.  Instead, I transfer it to my heirs as part of my estate.  They now own it.

             If my heirs then sell it for $10, must they pay tax on the $9 gain?  No, because of something called the step up in basis.  When my heirs inherit the stock, the basis “steps up” to its value on the date of my death.  So if it is worth $10 on date of death and they sell it for $10 the gain is zero.  All the unrealized gain (gain on which I never paid tax) is wiped out.

             This is a huge tax break for many families.  Dad purchased Microsoft or IBM stock many years ago and held it as it multiplied.  If he holds it till he dies and then his children inherit it, the tax on all that gain is gone.  This could amount to tens of thousands of dollars or more.  On the other hand, if Dad transfer the stock to the children while he is alive they get his basis, what is called a “carryover basis”.  They’ll have to pay tax on all the unrealized gain.

            Now that we know how the step up in basis works, next week I’ll tell you why President Obama’s proposal could miss the mark on targeting the wealthy and instead have a greater impact on the average person.

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