Phrases like “stepped up basis” tend to make the average person’s eyes glaze over. Everyone wants to maximize wealth and minimize expenses such as tax obligations. And, they want to avoid unnecessary tax burdens for their heirs. But, that doesn’t mean they want to delve into the complex interplay between lifetime and post-death transfers and capital gains taxes. And, decisions made without adequate information can be costly for everyone.

Fortunately, a basic understanding of what stepped up basis is and when it applies is sufficient to help you determine when you need to consult an estate planning attorney or financial adviser before taking action.

Capital Gains Taxes

In simplest terms, capital gains tax is the tax a person pays when he or he sells an asset for more than the tax basis of the asset. The tax basis is calculated using the initial purchase price of the asset (including certain fees), any investments in improvements, and depreciation.

Imagine, for example, that your parents purchased rental property when they were first married 50 years ago. Over five decades, that property will typically have significantly appreciated in value. So, if they decide to sell the property, there will be a significant difference between the tax basis (their initial cost, plus funds they’ve invested in remodeling and other improvements) and the proceeds of the sale. That difference is subject to capital gains tax.

Most people understand the tax ramifications of selling property that has appreciated significantly. However, what many overlook—to the detriment of their heirs—is the difference in how taxation plays out depending on when and how the property is transferred.

Lifetime Transfers and Capital Gains Taxes

As property owners age, many decide to transfer some holdings to adult children in their lifetime, rather than passing that property through a trust or estate. In some cases, that decision is part of a larger plan, such as Medicaid eligibility planning. However, some parents make the decision simply because the property is becoming burdensome for them to manage, or because the adult child has a use for it, or for some reason unrelated to long-term strategy.

Whether or not a transfer during the grantor’s lifetime makes sense is a holistic question that is best answered in consultation with an estate planning attorney, a tax professional, and/or your financial advisor. It is important to consider, however, that if that property is gifted during the grantor’s lifetime, the child receives it subject to the original tax basis. That means that when he or she sells the property, it will be subject to capital gains taxes using the same basis as would have been applied if the parent or parents had sold that property during their lifetime.

The amount of tax owed may be as great as the parents would have paid or, if the property continues to appreciate, significantly more.

Stepped Up Basis

When an asset is inherited, its tax basis is “stepped up” to it value on the date of the decedent’s death. The net result can be significant tax savings. Imagine, for example, that a parent purchased investment property in 1960, for $40,000, including fees. Over the years, he put another $60,000 into improving the property. In 2017, the property was valued at $450,000.

If he sold the property in 2017, $350,000 would be subject to capital gains tax.

If he gifted the property to his son, who held it for another year and then sold it at a 2018 value of $475,000, $375,000 would be subject to capital gains tax.

If he willed it to his son, who inherited in 2017, the basis would be stepped up to the 2017 value of $450,000. If the son then sold the property in 2018, just $25,000 would be subject to capital gains tax.

The precise calculation may be complicated, and valuation may be in dispute. In addition, there are many factors to consider in addition to capital gains tax, and the best plan for you will depend on your specific needs, priorities, and holdings. Be sure that you have considered all of the relevant issues and received the information and advice you need before making a decision about when and how to transfer significant assets—particularly if they have appreciated significantly.