Week 49 Day 6: The Step-Up in Basis: A Massive Tax Break at Death

How it works: You bought VTI for $50,000 in 2005. It is worth $300,000 when you die. If you had sold during your lifetime, you would owe capital gains tax on $250,000 of gain (approximately $37,500 at 15%). Instead, your heirs inherit at a basis of $300,000. If they sell immediately, they owe zero tax. If VTI grows to $350,000 before they sell, they owe tax only on the $50,000 of post-inheritance gain. This applies to stocks, bonds, mutual funds, ETFs, real estate, and most other assets in taxable accounts. It does NOT apply to retirement accounts (IRAs, 401ks) -- those are taxed as ordinary income to the beneficiary.

The step-up in basis creates a powerful planning rule: never sell highly appreciated assets in a taxable account if you intend to leave them to heirs. The capital gains tax you would pay during your lifetime is eliminated entirely at death. This changes the calculus on several common decisions: (1) Rebalancing in taxable accounts: if selling appreciated stock triggers a large gain, consider rebalancing through new contributions or within retirement accounts instead of selling the appreciated position. (2) Charitable giving: donate the appreciated stock directly to charity. You avoid the capital gains tax AND receive a tax deduction for the full market value. (3) The 'avoid selling the family home' rule: if your home has appreciated significantly, the step-up at death eliminates the gain for your heirs. The $250,000/$500,000 exclusion for primary residence sales applies during your lifetime but may be insufficient for large gains; the step-up eliminates this concern. (4) Tax-loss harvesting interacts with the step-up: losses you realize and deduct during your lifetime are real tax savings, while the gains you defer until death are eliminated through the step-up. This asymmetry makes tax-loss harvesting even more valuable. Important exception: the step-up does NOT apply in community property states to the surviving spouse's half of the community property... actually it DOES. In community property states, BOTH halves of community property receive a step-up at the first spouse's death -- a significant additional benefit.

The step-up in basis under IRC Section 1014 represents one of the most economically significant provisions in the Internal Revenue Code. The Congressional Budget Office (2019) estimated that the revenue cost of the step-up in basis (the 'Angel of Death' loophole as critics call it) is approximately $40-50 billion per year in foregone capital gains tax revenue, making it the single largest capital gains tax expenditure. The provision has been criticized by economists across the political spectrum as economically distortionary: it creates a 'lock-in effect' where rational investors hold appreciated assets longer than they otherwise would (reducing market efficiency and capital reallocation) simply to access the step-up at death. Auerbach (1991) demonstrated that the lock-in effect reduces the effective capital gains tax rate to approximately 50-60% of the statutory rate because wealthy investors systematically defer gains until death. Poterba and Weisbenner (2001) estimated that approximately 55% of all capital gains on assets held at death are never taxed due to the step-up, and the benefit is heavily concentrated among the wealthiest estates (the top 1% of estates capture roughly 50% of the total step-up benefit). Proposals to replace the step-up with 'carryover basis' (where heirs inherit the decedent's original cost basis) have been enacted twice -- in 1976 and 2010 -- and repealed both times due to complexity and political opposition. For financial planning purposes, the step-up creates a strong incentive to hold appreciated assets in taxable accounts until death, to use Roth conversions (which generate no stepped-up assets but provide tax-free withdrawals to heirs), and to donate appreciated stock to charity (which avoids both the capital gains tax and generates a charitable deduction at fair market value under IRC Section 170).