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Preparing for What Can Go Wrong, Investing in What Can Go Right - Part 2 - Blog 4

Preparing for What Can Go Wrong, Investing in What Can Go Right - Part 2 - Blog 4

| October 26, 2022

Here we are, folks, at our final week of preparing for the worst and positioning for the best, and this week we are going to talk about the stepped-up basis loophole! Huh? 

If you immediately thought, “oh, here comes the IRS mumbo-jumbo,” you are only half right because this mumbo-jumbo isn’t the bad kind! So, what the heck am I talking about?

Simply put, a stepped-up basis is a tax provision that allows heirs to reduce their capital gains taxes. When someone inherits property and investments, the IRS resets the market value of these assets to their value on the date of the original owner’s death. Then, when the heir sells these assets, capital gains taxes are applied based on this reset value. The result is a situation – often considered a tax loophole – that allows investors to pass assets to their heirs virtually tax-free. 

How does it work?

Let me use an example here to illustrate what all this means. Let’s say you purchased ABC stock twenty years ago at a cost basis of $20,000. Well, over those twenty years, ABC stock appreciated, and now it has a current value of $200,000. If you were to sell the stock, your capital gain or appreciation would be $180,000, and your tax liability would be somewhere around $27,000 at the 15% tax bracket, for example. 

But before you can do all this, let’s assume, for illustrative purposes only, of course, that you pass away and your child inherits the ABC stock for which your cost basis would have been $20,000. Well, when someone inherits stock, the Fair Market Value or FMV is “stepped-up” to the current appreciated value, which per our example, would be $200,000. 

So what does that mean? Well, this is the IRS delivering rare good news because the cost-basis for your heir is the FMV at the date of death, essentially creating a wash. If your heir were to sell ABC stock at its FMV of $200,000, which is the same as the sale price/current value, then the tax liability is zero because there is no gain or loss.

Pretty interesting, huh? But wait, there is one thing I want you to make sure you check on your own brokerage statements because even advisors miss this. Look at your brokerage account statements for the cost basis if you have inherited assets. 

I’m going to go back to my example of the $20,000 investment in ABC stock with a cost basis of $200,000. On your statement, you’ll see an appreciated asset with an FMV of $200,000. An appreciated asset simply means that it is an unrealized gain because it hasn’t been sold yet. Then, unfortunately, you pass away, and your kiddo gets your assets, including this one which means they have a cost basis of $200,000 based on the FMV at your date of death.

Well, here’s the issue - in many cases, the unrealized gain isn’t shown properly on the brokerage statement and isn’t reflecting the new basis. This can cause your heir a major problem because if it is not corrected so that the unrealized gain of $180,000 is shown as the basis, not the FMV, your heir would be left paying $27,000 or more in taxes. Now, if you need help with this, please reach out, but don’t be alarmed because it is simple to fix and a “good-to-know,” not a dire circumstance.

Well, I don’t know about you, but I feel better now that you have eight weeks' worth of information that can help you prepare for multiple financial scenarios, good or not-so-good. Come back next month, when I will be focusing on the cheery topic of preparing for your passing with a primer on life insurance. I’ll continue that theme with a focus on estate planning in the month of December.

Until next time…

One last thought, I believe an educated investor is an empowered investor. If you like what you’ve read and think your friends and family can benefit as well, please share.


1 Understanding Long-Term Care Insurance 

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested in directly.

All investing involves risk, including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

Dollar-cost averaging involves continuous investment in securities regardless of fluctuation in price levels of such securities. Investor should consider their ability to continue purchasing through fluctuating price levels. Such a plan does not assure a profit and does not protect against loss in declining markets.