What’s Your Basis? Shifting the Estate Planning Focus to Income Tax Savings
The way you transfer wealth to future generations matters from a tax perspective.
Generally speaking, transferring property at death is better than gifting property during your lifetime. An exception to this general rule exists if you and your spouse have (or are expected to have) a net worth that exceeds the federal lifetime gift and estate tax exemption amount (currently $11.58mm per person and $23.16mm per married couple).
Why does the timing and method of a gift matter?
It matters because of a concept called “basis”. “Basis” is a guidepost used to determine whether capital gains (or losses) will be imposed on a sale of assets. Your initial basis in an asset is its fair market value at the time you acquire it by purchase. When you later sell the asset, capital gains are imposed on the difference between the sales price and your basis. The formula looks like this:
Capital Gain (or Loss) = Sales Price – Basis
If you receive an asset by gift, your basis is “carried over” from the donor—in other words, you inherit the donor’s basis. By contrast, if you receive an asset by inheritance, the asset’s basis gets adjusted (stepped-up or stepped-down) based on the fair market value of the asset at the donor’s death. Let’s look at how the timing of a transfer can dictate the income tax consequences.
Example: XYZ Corporation
For purposes of this post, let’s assume that you purchase shares of stock in XYZ Corporation in 2020. The fair market value of your XYZ Corporation stock is as follows:
2020: $100 2021: $250 2022: $350 2023: $275 2024: $295 2025: $300Your initial basis in the XYZ Corporation stock is $100—the fair market value of the stock at the time you acquired it in 2020. When you sell that stock in 2021, the $150 in appreciation is treated as income in the form of capital gains.
Using the example above, let’s assume that you gift the stock to your son in 2021. Since you gifted the stock to your son, he “inherits” your basis of $100. Your son doesn’t pay capital gains tax at the time of the gift. However, when he sells the stock in 2025, the $200 in appreciation (e.g., $300-$100) would be treated as capital gains, and assuming a 15% long-term capital gains rate, he would pay $30 in income tax on the sale.
Now, let’s assume instead that the stock is passed to your son under your Will or Living Trust at your death in 2025. Since the stock was part of your estate, the stock received a “step-up” in basis based on the date of death fair market value of the stock. In other words, your son’s basis in the stock is now $300. If your son turns around and sells the stock while it’s still worth $300, no income tax is incurred.
Considerations
As you can see from the simplified example above, holding assets until death can be helpful to the beneficiaries of your estate, because they will pay less income tax when they sell inherited property in the future.
The vast majority of Texans are not facing estate tax liability under current federal laws. For those of us that do not have an estate tax problem, our focus should shift to maximizing the income tax benefits of our estate. Here are a few simple ways to maximize these income tax benefits:
Pass Property Via Will or Trust: Hold appreciated property until your death, at which time the assets in your estate will receive a basis adjustment based on date of death values.
Review and Update Existing Estate Plans: You should have an attorney look into whether your current estate plan utilizes the basis adjustment rules.
o Many older estate plans were designed to keep a certain portion of the first spouse’s assets outside of the surviving spouse’s estate. As a result, the assets put in trust at first spouse’s death will not receive a basis adjustment at the surviving spouse’s death.
o Under these older plans, which were created when estate tax exemptions were much lower, families are missing out on potentially significant income tax savings—especially when there’s a large time gap between the death of the first spouse and surviving spouse.
Irrevocable Doesn’t Mean Unchangeable: If a parent or spouse has died, it’s possible that an antiquated trust structure has been created under his/her estate plan that fails to account for the increased estate tax exemption amount and, as a result, keeps assets outside of the survivor’s estate.
o Even if a trust is “irrevocable,” it may still be possible to modify the trust to take advantage of the basis adjustment.
o Your estate planning attorney can assist you in reviewing the trust instrument and making the proper recommendations.
Conclusion
With federal estate tax exemption amounts at all-time highs, it is becoming increasingly important to take advantage of the income tax benefits available to your estate. If you have appreciated property, passing it to your beneficiaries at death will be more tax advantageous than gifting the property during your lifetime—especially if the beneficiaries plan to sell the property shortly after receipt. If you want to make gifts to your children, consider making cash gifts rather than gifts of appreciated assets.
If you have a parent or spouse that passed away recently with an older Will or trust structure, have an attorney review the plan to see what adjustments are available to maximize tax benefits available to the surviving spouse or children.
And finally, this is a good reminder to have your estate plan reviewed every 3-5 years. As mentioned above, planning strategies change frequently and are often dictated by changes in federal law. Maintaining close relationships with your financial advisor, accountant, and estate planning attorney will keep you abreast of these changes.
