Traditionally, a key goal of estate planning has been to minimize gift and estate taxes. However, because the exemption amount is at a record high of $5.43 million for 2015, fewer people will be liable for these taxes. Thus, many people have shifted their focus from estate planning to income tax planning. An understanding of basis — and the benefits of the “stepped-up basis” rule — can help you identify valuable tax planning opportunities.
What’s basis?
Generally, your basis in a capital asset is the amount you paid for it, adjusted, if appropriate, 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 an 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. Long-term capital gains are currently 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%.
What’s the stepped-up basis rule?
If you gift an asset, the recipient takes over your basis, triggering capital gains taxes in case the asset is sold. But if you bequeath an asset to someone via your will or revocable trust, the recipient’s basis is stepped up to the asset’s fair market value on the date of death. That means the recipient can 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 is gifting often viewed 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.
Consider this example: In 1984, Melanie bought stock for $400,000. In 1987, when the stock’s value had grown to $600,000, she transferred it to an irrevocable trust for the benefit of her son, Jeremy. At the time, the gift and estate tax exemption was $600,000, so Melanie’s gift was tax-free.
Ten years later, Melanie dies and the trust distributes the stock, then worth $1.8 million, to Jeremy. Jeremy sells the stock and, because he inherits Melanie’s original $400,000 basis, recognizes a $1.4 million capital gain. In 1997, the capital gains rate was 28%, so Jeremy pays $392,000 in taxes. But by gifting the stock in 1987, Melanie removed it from her estate, avoiding estate taxes on the stock’s appreciated value. Assuming Melanie’s estate was subject to the top tax rate (55% at the time), the estate tax savings totaled $990,000 (55% × $1.8 million).
In the example, the estate tax savings eclipsed the income tax cost, so gifting the stock was the better strategy. Today, however, the exemption has grown to $5.43 million ($10.86 million for married couples), so 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.
What about previous gifts?
Suppose you transferred assets to an irrevocable trust years ago to shield future appreciation from estate taxes, but now your wealth is comfortably within the exemption amount. Estate taxes are no longer an issue, but if your beneficiaries sell the assets they’ll recognize substantial capital gains. Fortunately, there are techniques you can use to restore the benefits of a stepped-up basis.
If the trust document permits, you can swap low-basis trust assets for cash or other high-basis assets of equal value. Done properly, this enables you to bring the low-basis assets back into your estate, where they’ll enjoy a stepped-up basis when you die.
Even if the trust doesn’t permit a swap, you may be able to purchase low-basis assets from the trust, with the trustee’s consent. It may even be possible to finance the purchase by borrowing the funds or exchanging a promissory note for trust assets. So long as the trust is a “grantor trust” — that is, a trust that you own for income tax purposes — a transaction between you and the trust isn’t a taxable event.
Handle with care
If you’re considering removing low-basis assets from a trust to reduce your beneficiaries’ income taxes, be sure to work with your advisor. One misstep can lead to unintended tax consequences.
Sidebar: Reverse gift minimizes capital gains
If you own highly appreciated, low-basis assets, a “reverse gift” can be an effective strategy for avoiding capital gains taxes. Here’s how it works: You transfer the assets to someone (your spouse, for example) whose health is declining, and that person leaves the assets to you in his or her will or revocable trust. When the person dies, you get the assets back with a stepped-up basis, enabling you to sell them tax-free. For this strategy to work, the person must survive for at least one year after you make the gift.
