When certain assets are sold, the seller owes capital gains tax on the difference between the sale price and the tax basis of the property, usually the amount invested in the asset. The sale of a personal residence is a good example; with some additional tax breaks built into our tax laws.

Similar tax breaks are available when property is inherited from a family member or friend. Under current law, if an asset is included in the decedent’s estate at death, it receives a step-up in tax basis to the date-of-death value. (Note: This does NOT apply to income-in-respect-of-a decedent—or IRD—items, such as qualified plan assets, 401(k) proceeds, earned income unpaid at time of death, annuities, or deferred compensation payments.) The theory involved is that, since estate taxes are being paid, there is no need to “double up” by adding income taxes on capital assets, such as businesses, real estate or many investments.

The heir/beneficiary receives the property with a tax basis equal to the date-of-death value, so that if they were to turn around and sell it the next day, little or no capital gains tax would be due (since the sale price and the tax basis would be nearly identical). Capital gains tax would be due on any growth in the asset between the date of death and sale date.

That’s the basic rule. It will change in 2010, when the estate tax is scheduled to disappear. As part of the deliberations and trade-offs on the 2001 tax law changes, it was decided that if estate taxes went away, step-up in basis would no longer be needed to avoid double taxation. However, since the new law also provides that we revert back to the current tax rates under the “sunset” provision in the law, we’ll be back to a step-up in basis in 2011.

Note that special rules apply to prevent someone from transferring property to a person near death. No step-up in basis is available when the property is acquired by the decedent within one year of death and then passed back to the original donor or the donor’s spouse at death.

The step-up in basis rule can be very advantageous for passing substantially appreciated assets on to the next generation. Consult your financial adviser for more details as to how this technique can work for you and your family. As always, you should consult your tax advisor regarding your individual tax situation, prior to taking any distributions.

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