A basic tenet of estate planning is to minimize gift and estate taxes. Yet with the exemption amount at $5.45 million for 2016 ($10.9 million for married couples), a vast majority of Americans won’t have to pay these taxes. For many, this means that estate planning focuses on income tax planning. And one of the most valuable tax planning areas is the “stepped-up basis” rule.
Generally, your basis in a capital asset is the amount you paid for it, adjusted to reflect certain tax-related items. For example, basis may be reduced by depreciation deductions or increased by additional capital expenditures. For purposes of this article, we’ll assume that basis is equal to an asset’s original cost.
If you sell a capital asset for more than its basis, you have a capital gain. If you sell it for less, you have a capital loss. Short-term capital gains (on assets held for one year or less) are taxed as ordinary income. For 2016, long-term capital gains are taxed at a maximum 20% rate for taxpayers in the highest bracket (0% for taxpayers in the two lowest tax brackets and 15% for all others). Certain high-income taxpayers are subject to an additional 3.8% tax on net investment income, bringing the capital gains rate up to 23.8%. Keep in mind that state income tax could increase the total tax rate significantly.
Stepping up basis
If you gift an asset, the recipient assumes your basis, triggering capital gains taxes if the recipient later sells the asset. But if you bequeath an asset to someone through your will or a revocable trust, the rules “step up” the recipient’s basis to the asset’s fair market value on the date of your death. This allows the recipient to turn around and sell the asset income-tax-free.
From an income tax perspective, it’s almost always better to hold appreciating assets for life, so your family members or other heirs can take advantage of a stepped-up basis. So why do many view gifting as the preferred method of transferring wealth? The answer stems from a time when high estate tax rates and low exemption amounts made estate tax avoidance the primary concern.
Using an example
Consider this example: In 2014, Jane bought stock for $2 million. In 2016, when the stock’s value had grown to $3 million, she transferred it to an irrevocable trust for the benefit of her son, Thomas. The 2016 gift and estate tax exemption is $5.45 million, so Jane’s gift is tax-free. Note that because in this example the gift was made to an irrevocable trust, the trust acquires Jane’s basis and there will not be a step-up in basis at her death.
In 2024, Jane dies and the trust distributes the stock, then worth $6 million, to Thomas. He sells the stock and, because he inherits Jane’s original $2 million basis, recognizes a $4 million capital gain. Assume that in 2024 the capital gains rate is unchanged from 2016 — 20% for those in the top bracket, plus the 3.8% Medicare tax. Then Thomas pays $952,000 in taxes. (State income tax may affect this number.) But by gifting the stock in 2016, Jane removed it from her estate, avoiding estate taxes on the stock’s appreciated value. Assuming Jane’s estate was subject to the top tax rate (40%), the estate tax savings totaled $2.4 million (40% × $6 million).
In the example, the estate tax savings eclipsed the income tax cost, so gifting the stock was the better strategy. With today’s high estate tax exemption, only the most affluent families are exposed to estate taxes. Unless your estate is (or will be) large enough to trigger estate taxes, transferring appreciated assets at death generally is the best tax strategy.
As you can see from the previous example, not knowing the difference between estate planning and income tax planning can lead to unintended tax consequences. Be aware also that, because basis is “reset” at death, it can also result in a step-down. Before you gift low-basis assets, consult your tax advisor.