It is often said the only certainties in life are death and taxes. Thanks to estate and inheritance tax, it is not uncommon for them to occur simultaneously.
However, there is a commonly overlooked tax benefit that can seriously help to minimize taxes that might otherwise have been owed when inheriting assets — a step-up in basis.
If you are unaware of how a step-up in basis works, you and your family could be missing out on significant tax savings.
So what is a “step-up in basis” and how does it work?
Your basis is usually what you paid for the asset. According to the IRS, a capital gain or loss is the difference between your basis and the amount you get when you sell an asset. In other words, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain.
For example, if you had purchased stock many years ago for $10 a share and sold it today for $75 a share, the $65 per share gain would have to be taxed.
These capital gains taxes will vary depending on whether they are considered short-term gains (assets held less than one year and taxed as ordinary income) or long-term gains (assets held for more than one year and taxed between 0 percent and 23.8 percent, depending on your income level).
See IRS publication 550 for more information on classifications.
While capital gains taxes can be significant, it is possible to avoid this tax altogether — let your heirs inherit the asset. When someone inherits an asset, the cost basis of the asset is “stepped up to value” on the date of death.
For example, let’s assume that an elderly parent leaves a home to their children that is valued at $400,000 on the date they pass away and the cost basis of the property is only $100,000. (The home was purchased 25 years ago).
While the beneficiaries may have to pay estate or inheritance taxes depending on the size of the estate, they will not be responsible for capital gains tax on $300,000 worth of gains.
Since they received a step-up in basis, they will only be responsible for gains that might occur from the point they inherit the asset and then sell it.
For example, if the beneficiaries later sell the home for $425,000, only the $25,000 is considered a gain as it represents the increase in value after the original owner passed away.
How do taxpayers miss this opportunity?
Often gifting is selected as the preferred means of transferring wealth.
It is important to examine the cost basis of assets prior to gifting.
According to estate planning attorney Robert F. Muñoz, a partner at Lomurro, Davison, Eastman & Muñoz, “Too often an emphasis is made on gift giving in order to avoid a modest amount of estate tax with the recipient of the gift ultimately being confronted with a large capital gain to be paid upon the sale of the gifted item. Holding the property rather than gifting the property to the beneficiary could relieve that beneficiary of any capital gains tax if there is no additional gain on the value of the property. As a result, all highly appreciated property should be examined in detail.”
The bottom line? Be careful gifting highly appreciated assets as it could result in capital gains taxes that could have been avoided.
A half step-up in basis
A quirky half step-up in basis can apply to certain situations.
For instance, when assets are owned by joint tenants with rights of survivorship between spouses and one spouse passes away, a partial increase in basis may apply.
Let’s assume that stock owned jointly with rights of survivorship was originally purchased for $50,000 and is worth $100,000 on the date one of them passes away. The new basis for the surviving spouse would be equal to the fair market value on the date of death plus the original basis divided by 2 or $100,000 + 50,000 / 2 = $75,000. In other words, half of the assets receive a stepped up basis — not too bad.
While utilizing a step-up in basis can lead to big tax savings, there are limitations to consider.
First, this does not apply to assets held jointly with children. Additionally, it does not apply to tax deferred accounts such as IRAs or 401(k)s.
Also keep in mind that assets also can receive a “step down” in basis depending on the value.
Optimizing an estate plan to minimize inheritance, estate and capital gains taxes is no easy task. Complexities in the tax code certainly do not make it easy for the average person to address these issues.
Since everyone’s situation is unique, consider speaking to your legal, tax and financial advisers to determine the most appropriate planning approach for you.
Kurt J. Rossi, MBA, CFP®, CRPC®, AIF® is a CERTIFIED FINANCIAL PLANNERtm Practitioner & Wealth Advisor. He can be reached for questions at 732-280-7550, kurt.rossi@Independentwm.com, www.bringyourfinancestolife.com & www.Independentwm.com. LPL Financial Member FINRA/SIPC.
