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Widows: Take your Step-Up to Reduce Taxes

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Most married couples own at least some of their real estate and other investments jointly with right of survivorship. That means that when one spouse dies, the ownership of the entire investment passes to the survivor.

This set up makes a lot of sense for married couples with modest estates who want everything they own to pass to the surviving spouse. In most cases, assets pass to the survivor with no state or federal death taxes, and no need for probate or other estate complications.

But, I’ve found that the simplicity of this set up can cause the survivor to overlook a significant income tax consequence that takes place. The survivor’s tax basis in the formerly co-owned investment may have changed. If the investment increased in value during between the time of the couple purchased it and the death of the first spouse, the survivor should receive a “stepped up” basis that will reduce the income taxes due when the investment is eventually sold. But this change in tax basis is often missed.

The step-up in basis rule applies to the assets you own (like stocks and bonds, real estate, and valuable collectibles) that are subject to capital gains taxes when sold.

The rule says that when you receive a capital gain asset from a decedent your tax basis in that property is not what the deceased paid for it. Instead it is normally “the fair market value of the property at the date of the decedent’s death.” Internal Revenue Code Section 1014a.

This section of the tax law means that the appreciation in value of the asset that occurred during the lifetime of the decedent on the portion he or she owned will never be subject to capital gains taxes. When you later sell the asset capital gains taxes will be due only on that portion of the sales price that is in excess of the stepped-up basis you received. This can save you a lot in taxes.

Here is an example of how this works.

Let’s say that a few years ago my wife and I bought a vacation cabin for $50,000. We titled it in both of our names with right of survivorship. That $50,000 purchase price was our initial tax basis in the property ($25,000 for my wife and $25,000 for me.)

Then my wife died. At the time of her death, the cabin was worth $90,000. If I sell the cabin for $90,000 I am going to have to report the sale and pay taxes on the difference between what I receive from the sale and my tax basis in the property.

But what is my tax basis? Many widows/widowers will report what was paid for the property (i.e. $50,000) as their tax basis. In the example above, this would mean they would pay capital gains tax on $40,000 – the difference between the sale price ($90,000) and the purchase price ($50,000). But that is wrong and will result in the overpayment of income taxes.

My tax basis in the vacation cabin is actually $70,000 rather than $50,000. And I should be paying tax on only $20,000 of gain, not $40,000. Here is why:

The tax basis on the ½ of the property that I inherited from my wife was stepped up from $25,000 to $45,000 (1/2 of $90,000) due to her death. My tax basis in the property is the total of what I paid for the ½ interest I purchased ($25,000) plus the date of death value of the ½ interest I inherited from my wife ($45,000). $25,000 plus $45,000 gave me a new tax basis of $70,000 in the property.

The step up in basis rule is found in the tax law at Title 26, US Code, section 1014. (Note that the step-up in basis rules are different and can be even more advantageous to the surviving spouse in the 9 states that follow community property rules – check with your tax advisor. But Pennsylvania is not one of those states).

Don’t overpay your taxes. Be sure to get a “date of death” value and update the tax basis on any capital gain assets you receive as the result of someone’s death.

This is one of a number of articles I have written about legal and financial planning mistakes made by retirees. Here are links to some others that might be of interest to you:

Avoid this Mistake: Taking Social Security too Soon

Three Estate Planning Mistakes People Make all the Time

Don’t Try this at Home: Do-it-yourself Wills are Dangerous