What is the difference between carryover basis and a step-up in basis?
The difference is whether heirs who sell an inherited asset will pay tax on the capital gains from the time the asset was originally purchased or from the time they inherited it. In some cases, the difference is a lot of tax liability.
A capital gain occurs if a capital asset is sold or exchanged at a price higher than its “basis,” the original purchase price with some adjustments. When a person inherits an asset, the basis becomes the fair market value of the asset at the time of the owner’s death. This is called a “step-up in basis” because the basis of the decedent’s asset is stepped up to market value. With gifts made during the giver’s lifetime, the recipient retains the basis of the person who made the gift (“carryover basis”).
The unrealized gain (or loss) on assets given by gift or bequest is not included in the income of the donor. The recipient is not subject to income tax on the asset’s value at the time it is received, but generally must include any gain if the asset is subsequently sold or otherwise disposed of. The realized gain is the amount received from the sale of the asset less the asset’s basis. For most sales, the basis is the amount the taxpayer invested in the asset, adjusted for subsequent improvements, depreciation, and certain other items. For gifts and inheritances, however, special basis rules apply.
For gifts, the basis remains the same as when the asset was held by the person who made the gift (“carryover basis”), but with an adjustment for any gift tax paid. For inheritances, the basis is the fair market value of the asset at the time of the donor’s death (or six months afterward, if the alternative valuation date is elected by the executor). This is referred to as “step-up in basis” (or “stepped-up basis”) because the previous basis is stepped up to market value.
The effect of carryover basis on gifts is to tax the unrealized gain accrued by the donor when the recipient sells the asset. The effect of step-up in basis on inheritances is to eliminate income tax on any unrealized gain accrued by the decedent.
The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) repealed the estate tax for 2010. But instead of allowing recipients the full step-up in basis in effect up until that year, it limited their step-up to $1.3 million (plus an additional $3 million for surviving spouses) with any additional unrealized gains carried over. Although the EGTRRA rules for 2010 were subsequently replaced, executors could elect EGTRRA treatment for 2010 decedents (and, in some cases, had a financial incentive to do so). So some deferred tax on the additional unrealized gains of decedents for whom an election was made will be paid by heirs under the income tax.
Joint Committee on Taxation. 2015. “History, Present Law and Analysis of the Federal Wealth Transfer System.” JCX-52-15. Washington, DC: Joint Committee on Taxation.