The Low-Basis Trap: When Tax Efficiency Becomes a Wealth Destroyer
The Low-Basis Trap: When Tax Efficiency Becomes a Wealth Destroyer
๐ WHO THIS IS FOR
- Target Profile: U.S. taxpayers with investable assets of $2M โ $10M+.
- Primary Objective: Tax Minimization & Intergenerational Transfer (Preserving the Step-Up).
- Not Suitable For: Active traders, Day traders, or investors holding assets in Tax-Deferred accounts (IRA/401k) only.
EXECUTIVE SUMMARY
- The Theory: Standard advice says “Hold Bonds in IRAs and Stocks in Taxable.” If your portfolio drifts, software suggests selling to rebalance.
- The Trap: If you hold a legacy stock (e.g., Apple bought in 1999) in a Taxable Account, your Cost Basis is near zero. Selling it to “optimize” location triggers a voluntary tax event (23.8% Federal + State) that destroys more wealth than the optimization saves.
- The Rule: The “Lock-In Effect” dictates that once an asset’s unrealized gain exceeds ~50%, the cost of liquidation outweighs the benefit of diversification.
- Authority Baseline: This analysis adheres to the optimal liquidation protocols defined by Kitces & Pfau, prioritizing the preservation of the IRC ยง 1014 “Step-Up in Basis.
Scenario: A California Resident (Top Bracket), Age 62, with $5M Taxable Portfolio.
- The Asset: Holds $1M of Apple Stock bought for $50,000 (Basis). Gain: $950,000.
- Action A (Sell & Rebalance):
Tax Rate: 23.8% (Fed) + 13.3% (CA) = 37.1%.
Tax Bill: $950k * 37.1% = $352,450 Immediate Loss.
Impact: Portfolio drops to $647,550. You need a +54% return just to break even. - Action B (Benign Neglect):
You hold the stock until death.
Step-Up Event: Heirs inherit at $1M basis.
Tax Bill: $0.
Result: You preserved $350k of family wealth by doing nothing.
BMT Verdict: This is a structural rule, not an optimization choice. For low-basis assets held in taxable accounts, the “Step-Up in Basis” is the most powerful tax shelter in the U.S. Code. Disrupting this shelter to save 0.5% on dividend drag is mathematically indefensible.
Wealth Destruction Comparison
| Action Taken | Immediate Wealth Destruction (Tax Cost) |
|---|---|
| Keep Asset (Benign Neglect) | 0 |
| Sell & Rebalance (CA Resident) | 352450 |
*Chart Note: The bar chart illustrates the immediate loss of principal due to taxes. The “Zero” bar represents the power of holding. A low-basis asset essentially becomes a “Restricted Stock” that should be treated as illiquid.
Historical Context: In 2021, the “American Families Plan” proposed eliminating the Step-Up in Basis for gains over $1M. This caused panic selling among HNW investors. However, the proposal failed. As of 2025, IRC ยง 1014 remains the law of the land. Until Congress explicitly changes this, holding until death remains the primary directive for legacy assets.
โ BOUNDARY CLAUSE: This Structure Breaks Down If:
- Asset Size falls below $500k: If the position is small, the complexity of managing around it may not be worth the tax savings.
- Single Stock Risk is Existential: If the stock is 80% of your Net Worth (e.g., Enron scenario), tax avoidance is secondary to survival. You must hedge or diversify (using Exchange Funds or Options).
- Legislative Change: If the Step-Up in Basis is repealed (legislative risk), this entire strategy must be liquidated immediately.
Execution Protocol
Review your taxable account. Any position with >50% unrealized gain is “Locked.” Mark it as “Do Not Sell” in your Investment Policy Statement (IPS).
If your Locked Asset is a US Large Cap Stock (e.g., Apple), sell your S&P 500 funds in your IRA and buy Bonds or International Stocks there to restore the overall 60/40 balance. Rebalance around the immovable object.
When you make your annual charitable gift, never use cash. Always transfer the “Locked” shares to a Donor Advised Fund. This is the only “tax-free exit” available while you are alive.
If these conditions are met, deviation from this holding strategy increases tax risk significantly. This protocol prioritizes “After-Tax Wealth” over “Pre-Tax Variance.”
WEALTH STRATEGY DIRECTIVE
- Do This: Enable “Specific ID” cost basis method at your brokerage. When you sell, choose the shares with the Highest Cost Basis (least gain) to sell first. Keep the low-basis shares until death.
- Avoid This: Using “Average Cost” basis. It blends your low and high basis shares, forcing you to realize more gain than necessary.
Frequently Asked Questions
Can I borrow against it?
Yes. Use a Securities Based Line of Credit (SBLOC). You can borrow usually 50-70% of the value at variable rates (SOFR + Spread) without selling. This provides liquidity without triggering the tax event. (Buy, Borrow, Die).
What is an Exchange Fund?
It’s a private partnership where many investors pool their concentrated stocks (Apple, Google, etc.). You swap your single stock for a diversified basket tax-free. Requires Accredited Investor status ($5M+) and 7-year lockup.
Does step-up apply to joint accounts?
In Community Property states (CA, TX), both halves get a step-up when the first spouse dies. In Common Law states (NY, FL), only the deceased’s half gets a step-up. Planning is crucial here.