Abstract: If gift and estate taxes aren’t a concern for many affluent families, it pays for them to focus planning efforts on income taxes — in particular, basis planning. This article details the benefits of a stepped-up basis. A sidebar explains how a recent IRS rule may affect basis reporting.
Tax basis planning offers significant benefits
For many people, income tax planning offers far greater tax-saving opportunities than estate tax planning. A record-high gift and estate tax exemption — currently $5.45 million ($10.9 million for married couples) — means that fewer people are subject to those taxes than ever before.
If gift and estate taxes aren’t a concern for your family, it pays to focus your planning efforts on income taxes — in particular, basis planning.
Benefits of a “stepped-up” basis
Generally, your basis in an asset is its purchase price, reduced by accumulated depreciation deductions and increased to reflect certain investment costs or capital expenditures. Basis is critical because it’s used to calculate the gain or loss when you or a loved one sells an asset.
The manner in which you transfer assets to your children or other beneficiaries has a big impact on basis. If you transfer an asset by gift, the recipient takes a “carryover” basis in the asset — that is, he or she inherits your basis. If the asset has appreciated in value, a sale by the recipient could trigger significant capital gains taxes.
On the other hand, if you hold an asset for life and leave it to a beneficiary in your will or revocable trust, the recipient will take a “stepped-up” basis to equal the asset’s date-of-death fair market value. That means the recipient can turn around and sell the asset tax-free.
Gifting in action
Given the income tax advantages of holding appreciating assets for life, why would you transfer assets via gift? Historically, gifting was viewed as the preferred strategy because it offered estate tax savings that outweighed the potential income tax costs. Let’s look at an example:
In 1991, Jennifer buys $300,000 worth of stock. (For purposes of this example, assume the stock is her only asset.) Two years later, the stock’s value has climbed to $500,000 and Jennifer transfers it to an irrevocable trust for the benefit of her daughter, Mollie. At the time, the gift and estate tax exemption was $600,000, so her gift to the trust is tax-free. In 2001, when the stock’s value has grown to $1.5 million, Jennifer dies and the trust distributes the stock to Mollie, who immediately sells it. Because Jennifer transferred the stock by gift, Mollie’s basis in the stock is its original purchase price of $300,000. As a result of the sale, she recognizes a $1.2 million gain, generating $240,000 in capital gains tax (20% of $1.2 million).
Had Jennifer held onto the stock — either directly or through a revocable trust — and left it to Mollie at death, Mollie would have received a stepped-up basis and avoided the $240,000 capital gains tax. But in 2001, when the exemption was only $675,000, the $1.5 million bequest would have generated $335,250 in estate taxes.
In this scenario, gifting an appreciating asset is the better strategy. But things have changed. If our hypothetical took place today, gift and estate taxes wouldn’t come into play, so Jennifer would achieve greater tax savings by holding onto the stock and providing Mollie with a stepped-up basis.
In general, unless your wealth is great enough to trigger estate taxes, your best tax strategy is to transfer appreciated assets at death rather than by gift. Of course, there may be nontax reasons to make gifts during your lifetime, such as helping one of your children pay college tuition or buy a home.
Undoing previous gifts
What if you transferred assets to an irrevocable trust years or decades ago — when the exemption was low — to shield future appreciation from estate taxes? If estate taxes are no longer a concern, there may be a way to help your beneficiaries avoid a big capital gains tax hit.
Depending on the structure and language of the trust, you may be able to exchange low-basis trust assets for high-basis assets of equal value, or to purchase low-basis assets from the trust using cash or a promissory note. This allows you to bring highly appreciated assets back into your estate, where they’ll enjoy a stepped-up basis when you die. Keep in mind that, for this strategy to work, the trust must be a “grantor trust.” Otherwise, transactions between you and the trust are taxable.
Is your basis covered?
As you develop or review your estate plan, be sure to contact us to determine whether your family would benefit from basis planning. Often, in today’s environment, the benefits of income tax strategies may outweigh the benefits of traditional estate tax strategies.
Federal legislation enacted in July 2015 added Section 1014(f) to the Internal Revenue Code. The provision requires consistent basis reporting between an estate and beneficiaries who acquire property from the estate.
If an estate is required to file a federal estate tax return, Sec. 1014(f) provides that the basis reported by persons who inherit property from the deceased must not exceed the final value of such property as determined for estate tax purposes. The act also requires executors to furnish basis information to beneficiaries and the IRS.
This means that a beneficiary who sells inherited property may not claim a basis higher than the value reported by the estate — at least not without challenging the estate’s valuation in court. Be aware that the new rules don’t apply to property whose inclusion in the estate doesn’t result in additional estate tax.