What is Step-Up in Basis?

B is correct. If Patricia bequeaths the stock at death, Jennifer receives a stepped-up basis equal to the $800,000 fair market value at Patricia's death. This eliminates the $775,000 of unrealized capital gains ($800,000 - $25,000). Jennifer can sell immediately with zero capital gains tax. In contrast, if Patricia gifts the stock during her lifetime, Jennifer receives Patricia's carryover basis of $25,000 and would owe capital gains tax on $775,000 when sold. The step-up benefit provides massive tax savings for highly appreciated assets.

A is incorrect because while Jennifer gets immediate access, she inherits Patricia's $25,000 cost basis and faces a $775,000 taxable gain. Even at favorable 15-20% long-term rates, this creates $116,250-$155,000 in tax liability. B is incorrect because the tax treatment is NOT equivalent; gifts carry over the donor's basis while inheritances receive step-up. D is incorrect because the annual gift exclusion ($19,000) only affects gift tax filing requirements, not capital gains tax. Jennifer still inherits the $25,000 basis and $775,000 unrealized gain regardless of the gift exclusion.

C is correct. Publicly traded stock receives a step-up in basis to fair market value at the date of death. The heir's new cost basis becomes $300,000, eliminating all unrealized capital gains that accumulated during the decedent's lifetime.

A is incorrect because traditional IRAs do NOT receive step-up in basis. The entire IRA balance is subject to ordinary income tax when distributed to beneficiaries, regardless of the original contribution amounts. B is incorrect because 401(k) accounts, like all tax-deferred retirement accounts, do not receive step-up treatment. Distributions to heirs are taxed as ordinary income. D is incorrect because annuities (variable or fixed) do not receive step-up. The beneficiary pays ordinary income tax on gains above the original premium paid, with no basis adjustment at death.

A is correct. Step-by-step calculation:

Stepped-Up Basis (David's new cost basis):
- 5,000 shares × $180/share (FMV at death) = $900,000

Sale Proceeds:
- 5,000 shares × $185/share = $925,000

Taxable Capital Gain:
- $925,000 (proceeds) - $900,000 (stepped-up basis) = $25,000

Key concept: David's father's original $100,000 cost basis (5,000 × $20) is irrelevant. The step-up eliminates the $800,000 of appreciation during his father's lifetime ($900,000 - $100,000). David only pays tax on the $25,000 appreciation after inheritance ($185 - $180 = $5/share).

B ($800,000) incorrectly calculates the father's unrealized gain, which is eliminated by step-up. C ($825,000) incorrectly uses the father's original $20 basis: $925,000 - $100,000 = $825,000. This ignores the step-up benefit entirely. D ($925,000) is the gross sale proceeds, not the gain.

C is correct (the EXCEPT answer). Traditional IRAs and 401(k) accounts do NOT receive step-up in basis. These tax-deferred retirement accounts are subject to ordinary income tax on distributions to beneficiaries, with no basis adjustment at death. The entire account value (except for any after-tax contributions) is taxable as ordinary income when withdrawn, regardless of the account's appreciation during the decedent's lifetime.

A is accurate: The basis of inherited capital assets (stocks, bonds, real estate, tangible property) is "stepped up" to fair market value on the date of death (or alternate valuation date). B is accurate: Because the basis resets to FMV at death, all unrealized capital gains accumulated during the owner's lifetime are eliminated for tax purposes. If the heir sells immediately at FMV, there is zero capital gains tax. D is accurate: IRC Section 1223 provides that inherited property is automatically treated as held long-term, regardless of how long the heir actually holds it before selling. This ensures favorable long-term capital gains rates apply.

B is correct. Statements 1, 2, and 4 are accurate.

Statement 1 is TRUE: Gifted assets retain the donor's original cost basis (carryover basis). If the client gifts the stock during his lifetime, the children receive his $400,000 cost basis and face a $1.6 million taxable capital gain when sold. This is a significant tax disadvantage compared to inheritance.

Statement 2 is TRUE: Inherited stock receives step-up in basis to fair market value at death. The children's new cost basis becomes $2 million, eliminating the $1.6 million of unrealized gains. They can sell immediately with zero capital gains tax, demonstrating the powerful tax benefit of step-up.

Statement 3 is FALSE: Traditional IRAs do NOT receive step-up in basis. The entire IRA balance ($1.5 million) is subject to ordinary income tax when distributed to beneficiaries, regardless of original contributions or appreciation. There is no basis adjustment for tax-deferred retirement accounts. This is a critical distinction that students frequently miss.

Statement 4 is TRUE: Municipal bonds, like all capital assets, receive step-up in basis at death. Even though municipal bond interest is tax-exempt, capital gains from selling munis are taxable. The step-up to $500,000 eliminates the $50,000 unrealized gain. Note: while this provides a step-up benefit, the gain is relatively small compared to the stock position.