You may have heard the term “estate tax” as it pertains to the total value of someone’s estate when they die. With the current estate tax threshold at $15,000,000, a vast majority of filers will not owe federal estate tax. Even though many states have significantly lower thresholds, such as New York’s current threshold of $7,350,000, federal estate tax is relatively rare for most people.
However, there are numerous benefits to filing Form 706, the federal estate tax return, and it’s largely to benefit the living via stepped-up basis. Filing an estate tax return can help the decedent’s beneficiaries avoid capital gains taxes on inherited assets. Here’s why executors should file Form 706 even if they are not mandated to and no tax is owed.
Understanding the Basis of Assets and Form 706
One of the building blocks of taxation is cost basis. Think about buying stocks and selling them: if you buy low and sell high, you’ll pay capital gains tax on the difference between your purchase price (cost basis) and the sale price. If you bought $250 of stock last year and sold it for $1,000 this year, you are taxed on the $750 capital gain.
Assets can be far more complex than this, though. Especially if they’re inherently complex assets like real estate, or the assets were held for several years and changes were made. Improvements on residential and rental properties, stock splits and conversions, dividend reinvestments, depreciation, all of these transactions can increase or reduce the cost basis of an asset.
Using the typical American life expectancy as a barometer, your 80-year-old parent who purchased a lifetime of assets for a significantly lower cost than today’s prices would face staggering capital gains if they sold those assets while they were alive. Let’s say that the home they purchased for $50,000 is now worth $600,000. You don’t plan to live in that home, so you plan to sell.
Upon inheriting their assets when your parent dies, you can avoid capital gains tax on the home sale thanks to the stepped-up basis that kicks in when you file Form 706.
What is Stepped-Up Basis? How IRC §1014 of the Tax Code Works
Stepped-up basis is an incredibly beneficial tax provision that, as the name implies, steps up the basis of an inherited asset upon the decedent’s death. Whether you are selling a home, investments, art, or other high-value items, this tax provision under §1014 of the tax code essentially erases decades of unrealized gains that otherwise would’ve been subject to taxation.
It is important to keep in mind that stepped‑up basis occurs automatically under IRC §1014. Form 706 does not “create” stepped‑up basis. What Form 706 does is document valuations to protect beneficiaries in future IRS examinations. Form 706 is required only when the gross estate plus adjusted taxable gifts exceeds the federal exemption or when electing portability.
For instance, if your parent transferred the deed to the home to you while they were still alive, their original cost basis of $50,000 would carry over (carryover basis) to you and you could owe significant capital gains tax on the taxable portion of the proceeds when you sell the home for the current market value of $600,000. But if your basis is stepped up to $600,000 upon filing a federal estate tax return, the capital gains could be reduced to $0.
In most cases, you can exclude up to $500,000 of the gain from selling your primary residence if filing jointly. The exclusion is up to $250,000 for single filers. You must have lived there for at least two years in the past five years in order to be eligible. If the property you inherited is not your primary residence though, you won’t be eligible for the exclusion unless you make that home your primary residence for the next two years before selling. Since stepped-up basis is a powerful tax reduction tool, it can provide a solid workaround for selling inherited real estate if you don’t plan to relocate.
Stepped-up basis is a crucial element of long-term tax planning and legacy planning. But it doesn’t automatically happen just because your parent or other loved one has a will and still owned the property at the time of death. Filing a federal estate tax return on Form 706 is a necessary step to fully realize the benefits of stepped-up basis, even though a vast majority of estates are not actually obligated to file it.
How Form 706 and Valuation “Seal” Stepped-Up Basis
Filing Form 706 is what makes stepped-up basis official in the eyes of the IRS.
The IRS will have an official record of the stepped-up basis so that when you sell any of the inherited assets during your lifetime, there is a “bedrock” document to reference for why you are reporting little or no capital gains on an asset that has appreciated significantly regardless of whether federal estate tax is actually owed. This is why it’s important, and beneficial, to file Form 706 prior to making any major decisions regarding the sale of inherited assets.
Accurate valuation is also critical when making stepped-up basis official by filing Form 706. This is relatively simple for publicly-traded stocks and other financial assets, as institutions can readily provide values on the date of death.
More complex assets may require specialized appraisers and consultants, such as inherited interest in a business, valuable artwork and collectibles, and real estate. Professional appraisals and valuation engagements help formalize the new cost basis for inherited property and provide a solid defense for tax avoidance strategies.
Strategically Electing an Alternate Valuation Date
Generally, most executors will opt for the date of death when defining the market value of inherited assets on Form 706, as it is the simplest to reference. However, the IRS also allows executors the option to elect an alternate valuation date of up to six months after the date of death.
Executors may elect an alternate valuation date six months after death if it results in a lower estate tax or provides more favorable basis documentation. This election must be made on a timely filed Form 706 and applies to all assets in the estate.
Electing an alternate valuation date can make stepped-up basis an even more powerful tax savings tool. For instance, if the decedent owned a significant amount of mutual funds at the time of death then the stock market skyrocketed three months later, the alternate valuation date would provide an even larger stepped-up basis. Ultimately, the decision to elect an alternate valuation date would depend on the sum of the inherited assets so the executor can make an informed choice during what is often an overwhelming time.
Bottom Line: What Happens if You Don’t File Form 706?
If no estate tax is owed and Form 706 is not required, nothing is triggered by not filing. However, beneficiaries may lack clear documentation of the asset values at the date of death, which can make it harder to substantiate the stepped‑up basis years later if the IRS questions reported capital gains.
Dealing with the death of a loved one is a difficult and stressful time that also comes with layers of financial complexity. Executors often face tight deadlines and complex valuation requirements. MEDOWS CPA can prepare Form 706, coordinate appraisals, and ensure beneficiaries receive the full benefit of stepped‑up basis.help you navigating the taxation aspects of handling the estate while forming beneficial tax savings strategies,Contact us today to set up an appointment.
