So-called stepped up basis is a term most people have never heard of and even fewer understand; however, stepped up basis, as you will see, is a critical component in creating our unfair tax code.
The easiest way to explain a concept like this is through an example.
- Bill buys a stock portfolio for 200 thousand dollars.
- He owns the portfolio for 30 years. During that time, its value increases to a million dollars.
- Bill dies leaving the million-dollar portfolio to Steve.
- Steve inherits the portfolio with a cost basis of a million dollars (the value of the portfolio when it was inherited).
- Steve holds the portfolio for four years. During that time, the portfolio’s value increases to 1.3 million dollars.
- Steve sells the portfolio for 1.3 million dollars (its current value).
- Steve is taxed on the difference of his stepped up cost basis, a million dollars, and his sale price of 1.3 million.
This means Steve was only taxed on 300 thousand dollars worth of gain. The 800 thousand dollars of gain achieved during Bill’s life was never taxed. So, Bill and Steve together made 1.1 million dollars (the difference between what bill paid for the portfolio and what Steve sold it for). The government only taxed them on 300 thousand dollars of the 1.1 million gain.
Assuming Steve is Bill’s son, we now see how wealthy families use tax law to transfer huge sums of money from generation-to-generation and avoid paying taxes on much of it.