One of the largest tax savings events I have seen is when a client dies, and their assets receive a step-up in cost basis. If they owned land or stock they purchased for pennies on the dollar decades ago, their inheritors would have $0 in capital gains taxes if they decided to sell the assets after inheriting. Possibly saving them hundreds of thousands of dollars, depending on the size of the capital gain.
Step Up in Cost Basis After Spouse's Death
If you are married, and your spouse is expected to die before you, there is a specific strategy you can use to maximize the inheritor's tax savings. This strategy involves having the spouse expected to die first have all assets with a capital gain transferred into an individual account with their name on it at least one year before they die. Upon death, all taxable assets will receive a cost basis step up to the value as of the date of death. If assets are held in a joint account, they will only receive a 50% cost basis step-up, and if 100% are in the survivors' name, they will receive a 0% cost basis step-up (assuming separate property state).
Cost Basis Step-Up Example
Jon Smith owns $1 million worth of Apple stock that he purchased for $10,000 over 20 years ago. If he were to sell that stock today, he would have to pay taxes on $990,000, which, even at the 15% tax rate (assuming you spread out the sale), would be $148,500 in taxes due. If you sold it all in one year in NC, you would be taxed at the 28.55% tax rate (20% capital gains, 3.8% Medicare, and 4.75% state tax), giving you a tax bill of $282,655! However, if he died and his wife sold the stock the week after his death, the cost basis would be stepped up to look like he purchased the stock for $1 million as of his date of death, and she would owe $0 in taxes! His spouse could have saved over $250,000 by waiting to sell the stock and holding it in an account with solely her husband's name on it.
Cost Basis Step Up PotHoles
This strategy only works in a separate property state, which NC is. If you were in a community property state, it wouldn't matter who held the assets; they would all receive a 100% cost basis step up. Community property states in the US are (AZ, CA, ID, LA, NV, NM, TX, WA, WI).
Boomerang rule
Assets must be held in the account for over one year. If the deceased dies within a year of receiving the assets, they will boomerang back to the original transferer of the stock and miss out on the cost basis step-up.
Loss of control for surviving spouse
For this strategy to work, you must trust the soon-to-be deceased individual. Trust them to list you as the beneficiary upon death and trust them not to spend the money or sell the assets until then. This may be simple for a spouse, but you could technically pursue this strategy with a friend or family member, and the rules get a little more complicated there.
Don't Hold Capital Losses
If you die holding a stock with a capital loss, then the loss is lost. I recommend transferring all assets with a loss to the surviving spouse and all assets with a gain to the spouse expected to die earlier. Loss carryforward dies with the decedent, which means if a client is about to die with assets that have a loss, then transfer the assets with the loss to the intended beneficiary before death so they can use the loss against their future capital gains or use it in a tax loss harvesting strategy against their income.
Ill or Older Family Members and Step Up in Cost Basis
You could also transfer assets to an elderly family member if you own something with a large capital gain and have them leave it to you as a beneficiary after it receives a step-up in basis. You can only transfer up to $13.61 million in total asset value before facing gift taxes.
Cost Basis Step-Up and Estate Taxes
In 2024, the estate tax exemption is $13.61 million per person. Keeping less than that exemption in the deceased spouse's name may be beneficial to avoid the possible 40% estate tax. The surviving spouse will have more time to send funds above this limit to the family via the $18,000/yr/person gift allowance, a dynasty 529 plan, or various charitable strategies.
Closing
Although this strategy can be extremely valuable, none of us know when we will die. We could plan, and the spouse we expected to outlive the other ended up dying in a car crash on the way home. You could avoid this by moving to a community property state and receiving a full step-up no matter who dies. But at the end of the day, we have very little control over the end of our story. This is why we recommend balancing your wealth building with spending, giving some away, going on that trip, and not sweating the small expenses. I hope you found this helpful, and if you'd like to discuss tax planning strategies further, feel free to give me a call or email me.
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