How is the stepped up cost basis important?

The answer is that it saves you capital gains taxes. In the tax year 2013 long term capital gains tax is 15% of the profit over your cost basis. When you inherit assets you adopt the value that exists at death. There is a later 6 month evaluation option but that topic is too complicated to address here. Let me give you an illustration of how the step up works at the date of your hypothetical uncle's death and if he sold the property during his lifetime:

Your uncle bought Commercial real estate for $40,000 in 1928 and stock for $10.00 in 1988. When your uncle sells those assets or dies on March 30, 2010 the Commercial real estate is worth $800,000.00 and the stock is worth $80.00. If your uncle had sold this property just before his death he would have paid a 15% long term capital gains tax on the profit of the land and stock of $114,010.50 to the IRS. Any state of residence income tax would be extra. If on the other hand, your uncle decided to not sell but hold these appreciated assets to his death and you inherited the assets you could disregard his original cost basis and instead report the March 30, 2010 "stepped up cost basis" to the IRS and pay no capital gains tax.

I have a related point I wish to make here. That point involves lifetime gifting. Using the above illustration your uncle offers to give you the commercial real estate and stock. If your Uncle actually delivered the gift and you accepted, you would be gifted not only the property but his original cost basis. Uncle would also be obligated to file a Gift Tax Return and might have to pay a gift tax. When uncle died you would not get the "stepped up cost basis" and when you sold for the price in the illustration you would pay $114,010.50 in long term capital gains tax. Too often I see where this gift took place shortly before death to avoid a Probate. Read my flat fee Probate proposal on this web site and you can see that uncomplicated probates could cost under $2,000.00. There are some instances where the lifetime gift makes sense but that topic is too complicated for this short article.

The 2010 Tax Relief Act (ATRA) provides relief from the uncertainty I discussed in my Article concerning Estate taxes in August of 2010 and 2012. For decedents dying in 2013 non-spousal heirs inherit up to $5.25 million Estate Tax exempt with the surplus at a 40% top tax rate and a full step up in basis of all assets. Spouses continue to have an unlimited exemption from Estate Taxes. The exemption is indexed for inflation. The unused portion of a spouse's exemption is portable to the estate of the second spouse to die if the election is made by filing a 706 estate tax return in the first spouses' death.

I must add a disclaimer to be fair. This is a short article of a highly complex topic. You should have your circumstances reviewed with your Estate Planning/Probate/Trust Attorney.