Income tax aspects are an important part of estate planning. One of the most crucial of those aspects is
the distinction between the “carryover basis” rule for gifts and the co-called
“step up” in basis rule for inherited property.
Under the carryover basis rule for gifts, the donee usually
takes over the donor’s basis. So for
example, let’s say father Frank buys stock for $1,000. Frank is a savvy investor, and a few years
later the stock is worth $10,000. Frank
then gives the stock to daughter Diane.
Diane’s basis in the stock is $1,000, “carrying over” Franks basis. Consequently, if Diane sells the stock for
$10,000 she will have taxable gain of $9,000 (the difference between the $1,000
basis and the $10,000 sales price).
By contrast, inherited property gets a new basis equal to
its value on the date of death. This is
called the “step up” in basis – although of course it could be a step down in
basis in some cases, depending on the value of the property at death! The step up applies even if no estate tax is
due at death. All that is necessary is
that the inherited property be included in the federal gross estate. So going back to our example, let’s say
instead of making a gift when the stock was worth $10,000, father Frank died
and Diane inherited the stock from him at that time. In that case, Diane’s basis in the stock is
$10,000, equal to its value at the date of Frank’s death. Consequently, if Diane were to sell the stock
for $10,000, she would not have any taxable gain.
Traditionally, people were usually more concerned about estate
tax than income tax consequences. In the
first place, estate tax rates were much higher than long term capital gains tax
rates. In addition, estate tax was imposed at a much
lower level of wealth —for example, in 2004 there was only a $1.5 million
federal estate tax exemption. By
contrast, the federal estate tax exemption is now $5,340,000 (and is scheduled
to be increased for inflation in future years).
Meanwhile, the top federal estate tax rate is now lower at 40%, while the
top long-term capital gains tax rate is now 23.8% (including the ACA surtax), and
28.7% on average if state capital gains taxes are also taken into consideration. As a result, fewer people are paying estate
tax and planning to avoid capital gains tax has greater significance.
Interestingly, if assets have gone down in value from the
date of purchase, the gift basis for gain could actually be higher than the
inherited basis. Even if the fair market
value is lower than basis at the time of gift, if the property is later sold at
a gain the donee can still use the donor’s carryover basis. For example, let’s
say mother Meg buys stock for $1,000 and it goes down in value to $800. If Meg then gives the stock to son Sam, Sam’s
basis for gain is still $1,000, the “carryover” of Meg’s basis. On the other hand, if Meg dies and Sam
inherits the stock, Sam’s basis is only $800, the value of the stock at the
time of Meg’s death.
In such a situation a prospective donor like Meg might
choose to sell the property and take the loss assuming he or she can use
it. However, some property is not easy to
sell, and/or the donor may wish to pass certain property on to family members
regardless of its current value. In that
case, it may be better to gift the property to take advantage of the higher
carryover basis. To preserve the
opportunity to make such a gift it may be important to have a durable power of
attorney in place that grants broad gifting authority, as the donor may lack
capacity to make gifts in the period before death.
In the case of assets that have increased in value from the
date of purchase, if the estate will not be subject to estate tax it is likely better
from an income tax standpoint for the recipient to inherit the property and get
the step up than to receive it by gift – recognizing that there is no absolute
certainty that the estate will remain low enough to be non-taxable (and that
the tax law could also change again). In
this stratum of wealth the desire to actually include assets in the estate has
led, for example, to renewed interest in retained life estates, by which
property can be technically given away during life but yet included in the
estate at death to get the step up in basis.
If the estate is of a size that estate tax is likely to be a
concern then many factors -- including the overall size of the estate, post
gift appreciation, future exemptions and rates of tax and the basis of the
property -- will be relevant in evaluating whether a lifetime gift is likely to
be more beneficial than holding the asset until death. In general, this is a complex analysis but
may at a minimum argue in favor of making any gifts in trust to maintain some flexibility
in tax planning.
Disclaimer
– Postings Not Legal Advice
This
blog is not legal advice and no attorney-client relationship is formed. The information and materials on this blog
are provided for general informational purposes only and are not intended to be
legal advice. The law changes frequently
and varies from jurisdiction to jurisdiction.
Being general in nature the information and materials provided may not
apply to any specific circumstances.
Nothing on this blog is intended to substitute for the advice of an
attorney. If you require legal advice,
please consult with an attorney licensed to practice in your jurisdiction.
