By Ronda M. Gabb

One of the most important concepts an estate planning attorney should be familiar with is cost basis and the step-up in basis for their clients, especially when handling successions.  Giving wrong or incomplete advice to clients in this area can cause significant adverse tax consequences.  Unfortunately, we often see this occur with inexperienced attorneys handling successions.

What Is Cost Basis?

First, let’s discuss what “basis” is.  In short, it is the price you paid for an asset (like stock or real estate), or perhaps the value of a business that you started.  If the asset was donated to you, your basis is whatever the donor’s basis was. Some assets can be tricky because many of us also “depreciate” the asset that we own, especially if it is a piece of rental property.  That depreciation directly lowers your cost basis.  Depending on how long someone has owned an asset, their cost basis could even be ZERO.  This is why these very low-basis properties are usually sold through a “1031 exchange” during the life of the owner to defer the capital gains/depreciation recapture until death, and the step-up occurs.

How the Step-Up in Basis Works at Death

While death is sad and final, we also have to look at what “good” can come of it. One of those is the “step-up in basis,” which can significantly affect many people.  Here is a common scenario.  Our decedent, John Doe, died on July 1, 2024, owning a vacation home with a fair market value of $1,500,000.  John Doe purchased the property thirty years ago for only $250,000.  Had John sold this property during his lifetime, say on June 1, 2024, he would have had to pay significant capital gains taxes on his “profit” of $1,250,000.  For 2024, the federal capital gains tax rate assessed on the profit from assets held long-term (more than one year) is either 0%, 15%, or 20%, depending on your taxable status.  In this example, the tax rate would be the max of 20%.  For assets held short-term (less than a year), use your ordinary income tax rate; Louisiana will tax the gain, whether short or long, at up to a maximum of 4.25%.

However, when John Doe died on July 1, 2024, his beneficiaries/heirs/legatees received the property now at the “stepped-up basis” of $1,500,000.  If the property was sold on August 1, 2024, for $1,500,000, there would be absolutely ZERO capital gains (or Louisiana) taxes due!  Additionally, if the property was the COMMUNITY property of John Doe and his spouse, Jane Doe, then the entire property receives a step-up in basis, NOT just the community half of the deceased.  So even if Jane sold the property during her lifetime, her “new” basis now is “reset” to the $1,500,000. This is available only in community property states, and we often see the spouse’s ability to step up their share overlooked.

Why Accurate Valuation Matters in Successions

Now you see why it is critically important that succession attorneys ensure their clients provide accurate valuations of properties and business interests so their clients’ assets receive the “new” and proper step-up in basis when these assets are later sold.  If assets are “under-valued,” then the full step-up in basis may be jeopardized.

LAW-niappe

If the property is your primary home, and it has been your primary residence for two of the last five years (the two years is actually cumulative), then even during your LIFTETIME the sale of the home may qualify for what is called the “Section 121 exclusion from capital gains” for the first $250,000 of profit ($500,000 for a married couple), and you do NOT have to purchase another primary home.