For many of my clients, taxes are a big concern. In any event, tax consequences play and important role when crafting an estate plan. Fortunately, there are numerous estate planning tools and strategies that can help reduce, or even avoid, hefty tax obligations for you, your estate, and even your beneficiaries.
One of the key elements of estate planning is being thoughtful about when people inherit from you. I have clients with young children — or even adult children, who sometimes act like young children — who just aren’t ready to inherit and should have their inheritance managed for them through a trust. I also have a lot of older clients who consider that life might be simpler if they began transferring assets while they are still alive. Like a lot of things that seem simple, there can be hidden complications. In the case of lifetime gifts of assets subject to the capital gains tax, it can mean more than unexpected complexity: it can mean needlessly included this IRS among those who benefit from your gifts. It always helps to have a clear understanding of what is involved in calculating tax obligations for assets that are sold, gifted, or otherwise transferred during your lifetime or after your death. With that in mind, let me explain what a “stepped-up” basis is and why it matters.
What Is “Basis?”
Basis refers to the amount that the owner of an asset has invested in it. For example, what you paid for a stock or a piece of real estate. In the case of real estate, it can also include the cost of improvements or additions to the property. When the value of a property increases the basis does not change. When property subject to the capital gains tax is sold, there is tax on the gain, which is the difference between the basis and the amount for which the property is sold. The most common example of how basis is used for tax purposes is calculating capital gains taxes. Imagine that you purchased a vacation home ten years ago for $350,000 and recently sold the home for $750,000. You realized a “capital gain” of $400,000 on the sale. Therefore, capital gains taxes would be owed on that $400,000 profit.
If you give an asset subject to the capital gains tax to someone, your basis goes with the property. This is what is referred to as carry over basis. If you gave that vacation home away to you children and they sold it, they would have the same $400,000 profit and would pay the same tax. This does not have to be the case.
What Is a “Stepped-Up” Basis?
The concept behind a “stepped-up” basis is something that is critical to understand when thinking about when you should give something to those you hope to benefit from your estate. When it comes to these assets like stocks, investments and real estate, which are subject to the capital gains tax, you have to be aware of the benefit of “stepped-up” basis. If an asset passes to someone as a result of your death, and thus was included in your taxable estate, it gets an adjustment for capital gains tax purpose to the date of death value. This adjustment means that the capital gains tax liability on the property is wiped away. For example, if rather than giving that vacation home to your children they inherit it as a result of your death, their basis is no longer $350,000 but is instead the date of death value, $750,000. If they then sell the property, they have no tax because they have no gain. This would be a saving of tens of thousands of dollars in taxes.
You may be aware that you have an exemption on capital gains tax for your primary residence. If the house I have been talking about is your primary home rather than a vacation property, you would have an exemption upon sale which would eliminate you tax liability. However, that property is not the primary residence of your children and therefore, will be subject to capital gains tax in their hands. This is one an many reasons it is not a good idea to give your house away to your kids prior to your death.
Stepped-Up Basis and Jointly Owned Property
Calculating the potential tax implications of jointly owned property becomes more complex. In most states, the default method is to treat jointly-owned assets as “separate property” for tax purposes. As such, the amount that is included in a decedent’s estate is only 50 percent of the assets’ value, meaning only 50 percent of the value of the property will be eligible for a “step-up” in basis. The remaining 50 percent, (the surviving spouse’s half) keeps the original basis. By way of illustration, if the vacation house discussed above were owned jointly by two spouses in a common law property state, using a 350,000 basis and and a $750,000 value at the death of the first spouse to die, one-half of the basis will step up to the date of death value, while the other half would remain at the same level. The basis of the property in the name of the surviving spouse would be $550,000, as the half of the property belong to the spouse who died will increase in value from one-half of $350,000 to one-half of $750,000 ($375,000)while the basis of the surviving spouse’s half will remain at one-half of $350,000 ($175,000). This means there is still an impediment to lifetime gifting of the property to anyone other than the spouse because there is still a substantial gain in the property.
Estate Planning Can Help
The good news is that there are several estate planning strategies and tools that are aimed at addressing the tax issues associated with the complex rules surrounding basis in assets sold, gifted, or passed down after death. Consult with an experienced estate planning attorney to decide the best way for your estate to avoid paying unnecessary taxes.
Contact a Durham Estate Planning Attorney
If you have additional questions or concerns relating to tax issues and estate planning, please contact a Durham estate planning attorney at Clarity Legal Group by calling us at 919-484-0012 or contact us online.
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