Some recent buzz about proposed legislation made me want to cover a popular and sometimes confusing component of estate planning — the capital gains tax. Today, I want to show you how to avoid the dreaded capital gains tax with the help of the step-up in basis provision. Let me start by defining two key terms for today’s lesson:
- Step-up in basis: Readjustment of the value (for the purposes of income taxes) of an appreciated asset upon inheritance.
- Tax basis: Initial investment in an appreciated asset.
Whether these terms are unfamiliar to you or not, they are important to structuring your estate and maximizing the assets you can leave to your heirs.
Step Up In Basis: Tax Breaks for your Inheritance
What is a tax basis?
Some examples of capital assets include shares of stock, real estate, or a business. You acquired these assets at a point in time for a certain price, but they may have since appreciated in value; this is what’s called a capital gain, a form of taxable income. The capital gain is the sale proceeds of the asset minus the tax basis, the initial amount paid.
The tax basis for any asset is the price you paid for it. Taxes will only be assessed for the profit gained over the purchase price once you sell the asset. You may be surprised that capital gains taxes are relevant to many regular folks. Whether you’re dealing with stocks, a business, a farm, valuable collections, investment properties, or a residence, you’ll want to familiarize yourself with the tax basis and capital gains tax applicable to your property.
However, as you probably know, taxes for many things change significantly in retirement, especially when it comes to your estate. One example of how capital gains are treated differently when pertaining to your estate is the step-up in basis provision.
How step-up in basis can eliminate your capital gains tax:
While you may have heard some whispers about eliminating the step-up in basis, under current legislation no income taxes are incurred when appreciated assets are passed on to heirs. A step-up in basis is applied to your assets only after death.
For example, say you bought a house 25 years ago for $100,000; you’ve paid off your mortgage, and you now own the house outright. Lucky for you, the house has since gone up significantly in value and is now worth an estimated $400,000. With an otherwise modest estate, you want to leave your most significant asset, this house, to your son.
With a purchase price of $100,000 and a current estimated value of $400,000, you’ve netted an impressive $300,000 from this house. If you sell the house while you’re still alive, a capital gain of $300,000 will be taxed.
So the question is, should you sell the house now for your son and leave him the money, simplifying things for him after you’re gone? Or do you leave him the house itself? The answer has everything to do with the capital gains tax.
Capital gains taxes can be avoided when inheriting capital assets through the step-up in basis provision. By leaving the house itself to your son, the property undergoes a step-up in basis — a readjustment in value of the asset to reflect current fair market value ($400,000) as opposed to the original purchase price ($100,000). What this means is that the value of the house as it pertains to the IRS and any taxable income is “reset” before ownership is transferred to your heirs.
The IRS, in effect, ignores any capital gains you earned as the original owner of the asset when the property is passed on to your heirs. While our example discussed a home, the step-up in basis applies to any capital asset — e.g., other types of commercial or vacation properties, stocks, businesses, etc. — left to your heirs.
Many of our clients who have most benefited from the step-up in basis own family farms or small businesses.
Listen to learn more about capital gains taxes:
How are capital gains taxes applied to a primary residence?
If you’ve ever had success in the real estate or stock markets, you may already have experience with capital gains taxes. However, capital gains taxes behave differently when applied to the sale of a primary residence.
For a property to count as your primary residence, you will need to have lived there for at least 2 out of the past 5 years. If you meet these criteria, you may qualify for the IRS primary residence exclusion; this means that the first $250,000 in gains for a single person and $500,000 in gains for a married couple are exempt from taxes.
Let’s apply this to our earlier example, assuming the home is the primary residence of a single person. If he sells the house for $400,000 instead of leaving it to his son, the first $250,000 in gains from the sale are tax-free, leaving $50,000 in taxable gains (there would be no taxable gains for a married couple in this example as they are allotted a $500,000 exemption).
Not having to pay taxes on most of the money you get from the sale of your home can allow you greater financial flexibility when you are considering a move.
Capital gains taxes and charitable contributions:
Another exemption applies to charitable contributions of capital assets. If you don’t need the property or asset yourself and don’t have a person you’d like to leave it to, then you may want to consider a charitable donation instead. You can donate capital assets to a charity without placing a large capital gains tax burden on them, as charities are exempt from these taxes. If you have highly appreciated capital assets and want to make a charitable contribution, donating these assets will avoid the capital gains tax and will even provide a tax deduction for you.
For example, let’s say 50 years ago you bought 100 shares of a generic stock at $10/share; your original investment of $1,000 has since grown to $100/share or $10,000. Ordinarily, this $9,000 capital gain would be taxed. However, whether given all together or in chunks over time, donating these stocks to a charity will mean that none of the $9,000 in capital gains will be taxed — maximizing your donation.
How these strategies apply to you:
While avoiding the capital gains tax may seem the obvious choice when structuring your estate, there are a few factors you should consider.
Most importantly, we always urge clients to make the right decision based on the totality of their current needs and future goals — regardless of the incurrence of any capital gains tax. Some of the things you may want to consider are:
- Do you need the money from the sale of your house in the near future, or can you wait to include it in your estate for heirs?
- Do any of your children want the house, or would they prefer money? Will multiple children be able to work together amicably if gifted property to split?
- Is most of your money tied up in your property, making it the main source of generational wealth transfer?
- Are you single, or is your spouse still living and likely to outlive you?
As mentioned above, there has been some talk about possibly eliminating the step-up in basis. In effect, capital gains would be taxed, even on inherited assets. For now, however, these proposed changes are far from assured; in fact, no details on any specific legislation have been released, much less presented or voted on in Congress.
At Cardinal, we emphasize education when it comes to our clients. We make sure you are well informed about all your options before making these important decisions. Laws can change. And even the most straightforward of estates can be made complicated by complex tax codes and opaque rules.
We know making these decisions can be overwhelming, especially when your family will depend on these assets for financial security. If you want ease of mind, give us a call, and we will work with you to explore every option and opportunity available when planning your estate.