Step-Up in Basis and Why It Matters in Estate Planning

Recent news stories may have made you aware of the “step-up in basis” and the current administration’s desire to eliminate or adjust it.

If you are considering engaging in estate planning or you may be inheriting assets, it is important to understand what the step-up in basis is and how it may affect you.

What Is the Step-Up In Basis?

The step-up basis is a provision in federal tax law. It determines how assets are valued for calculating capital gains taxes when a person passes away, leaves these assets to heirs, and those assets are sold.

So, for example, imagine a person passes away and leaves their home to their children through their will.

When the children inherit the property, the home’s cost basis changes. (“Cost basis” is the amount for which an item is originally purchased.) The home’s cost basis is adjusted – or “stepped up” – from what it was valued at when the parent originally purchased the home to its fair market value on the date the parent died.

In this case, suppose the original cost of the home 30 years ago was $100,000, and the “stepped up” basis in 2022 (date of death) is $300,000.

If the children then sell the home for $500,000, the resulting capital gains liability is calculated by subtracting the stepped-up basis from the sale price. This determines the children’s taxable gain ($500,000 – $300,000 = $200,000 gain). The effect is that the capital gain between the original purchase of the home and the children’s receipt of it is eliminated.

In other words, without the step-up in basis, the children who inherited the property would have had a considerably higher taxable gain after the sale ($500,000 – $100,000 = $400,000 gain). As a result, they would then have potentially had to pay more in capital gains tax.

Why Bequeath Assets Through a Will or Estate Plan?

Passing assets, such as the home in the example above, to your loved ones through your will or estate plan means those who inherit are often subject to much lower capital gains tax than if the assets were outright transferred or given to your loved ones during your life.

This is because assets transferred or gifted before death are subject to the purchaser’s cost. Capital gains tax is then calculated based on the differential between the original cost basis and the sale price (after considering any depreciation or other capital gains exclusions that may apply).

What Assets Step Up In Basis Upon a Person’s Death?

The step-up in basis can apply to many kinds of assets, including:

  • real estate
  • personal property
  • brokerage accounts
  • stocks
  • bonds
  • bank accounts
  • businesses
  • art
  • antiques
  • collectibles
  • and much more

Gifting or bequeath these types of assets through your will or estate rather than giving them away during your life can make a big difference for your heirs.

In addition, under federal law, all community and marital property gets a new basis when the first spouse dies. Their death brings the property up to the fair market value at that time. So, a surviving spouse could sell these assets and take advantage of this adjusted basis. And, subject to certain exceptions, the qualifying property of the surviving spouse can also receive a second step-up in basis at their death.

When Does the Stepped-Up Basis Not Apply?

While some assets qualify for a stepped-up basis, some can lose the ability to receive an adjusted basis.

For example, a surviving spouse cannot benefit from a second step-up in basis for assets that had been placed into an irrevocable trust before the first spouse’s death.

The stepped-up basis also does not apply to the following types of assets:

  • IRAs
  • employer-sponsored retirement plans
  • 401(k)s
  • pensions
  • tax-deferred annuities
  • gifts made before death
  • and some other assets

When Are Capital Gains Taxes Assessed?

Capital gains are taxed when an asset is sold (for a profit).

In the above example, if the house is sold three years after the parent’s death for $700,000 (which would mean it increased in value by an additional $400,000 during this time), then capital gains tax is potentially due on $700,000 (sale price in 2025) – $300,000 (stepped-up basis at date of death) = $400,000 of gains.

It is assessed and payable for the tax year in which the post-death sale occurred, and liability effectively shifts to the heirs who benefit.

Why Do Some Believe the Step-Up in Basis Should Be Eliminated?

Many believe the stepped-up basis creates an inequitable tax loophole that allows people with significant assets to shelter these assets from capital gains tax if they dispose of them through their estate.

For example, in the scenario above, if the home was initially purchased for $100,000 and sold by the heirs of the purchaser for $1,000,000 shortly after the purchaser’s death, $900,000 of capital gains would effectively never be taxed.

Meanwhile, someone who sell their assets during their lifetime will likely not get equal tax benefits (even considering the $250,000 personal residence capital gains exclusion) and may face a hefty capital gains tax bill.

On the other side of this argument are those who posit that not having a stepped-up basis can lead to double taxation. From their viewpoint, heirs or an estate would face capital gains tax as well as potentially significant estate tax.

This would likely only affect those with a good amount of wealth, given the current federal estate and gift tax exclusion, which will rise from $12.06 million in 2022 to $12.92 million in 2023. Most people will not fall into this category. Because of this, the tax revenue that the government could raise by eliminating the step-up-basis could arguably outweigh the double taxation issue.

However, this could all change after 2025, when the federal exclusion is set to be cut by approximately half. This will potentially affect a much larger group of people. The argument may not be so strong under those circumstances.

Navigate Estate Planning With a Qualified Attorney

Planning to avoid capital gains taxes is a complex endeavor that a person should only undertake with the assistance of a qualified professional. Every person’s situation is different, and there is no one-size-fits-all solution.

While saving money on capital gains may seem attractive, there may be situations where leaving assets to heirs upon your death may not be the best plan or may create more significant tax issues. In addition, it may not be the best strategy if, for example, you need to engage in Medicaid planning.

Contact your attorney for answers to questions about capital gains taxes and whether you or your loved one may benefit from a step-up in basis.

How Community Property Affects Estate and Tax Planning

In most states, spouses can purchase and own property separately from one another. However, in certain states – called community property states – if one spouse purchases property, it is considered the property of both spouses. How marital property is owned has implications for both estate and tax planning.

There are currently nine community property states. They are: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. A few other states (for example, Alaska) allow couples to opt into community property arrangements.

Community property is property acquired by a husband and wife during marriage. In community property states, property held in only one spouse’s name can still be community property. For example, the paycheck that a spouse brings home every week is community property even though only one spouse’s name is on the check. If that check is used to buy an asset, then that asset is community property, regardless of whose name is on the account or the asset.

Property that is not community property is property that one spouse brings to the marriage, inherits, or is gifted. A spouse can turn separate property into community property by putting an asset owned by one spouse into both spouses’ names.

Depending on the state, partners may be able to change whether property is separate or community via pre-nuptial agreement, post-nuptial agreement, or exceptions in the law. Changing community property into separate property may be appropriate in second marriages or when one spouse is bringing significant separate property into the marriage. For example, if, at the time of the marriage, one spouse receives significant income from owning a business, the spouses may decide that it is appropriate that the business remain that spouse’s separate property and the income from that property will remain that spouse’s separate property.

One advantage of community property is with regard to capital gains taxes. If one spouse dies, the cost basis of the community property gets “stepped up.” The current value of the property becomes the cost basis. This means that if, for example, the couples’ house was purchased years ago for $150,000 and it is now worth $600,000. The surviving spouse will receive a step up from the original cost basis from $150,000 to $600,000. If the spouse sells the property right away, he or she will not owe any capital gains taxes. In non-community property states, if one spouse dies, only the deceased spouse’s interest (usually 50 percent of the value) is stepped up.

When estate planning in a community property state, it is important to fully review assets to determine which assets are community property and which are separate property. A surviving spouse in a community property state is entitled by law to half of the community property, regardless of what the spouses may have wanted to do with the property (such as pass it on to children). Community property can be a factor even in non-community property states if the couple owns property in a community property state.

If spouses move from one type of state to another, it is especially important that they have their estate plan reviewed by an attorney in the new state to make sure the plan still does what they want.

The Tax Consequences of Selling a House After the Death of a Spouse

If your spouse dies, you may have to decide whether or when to sell your house. There are some tax considerations that go into that decision.

The biggest concern when selling property is capital gains taxes.  A capital gain is the difference between the “basis” in property and its selling price. The basis is usually the purchase price of property. So, if you purchased a house for $250,000 and sold it for $450,000 you would have $200,000 of gain ($450,000 – $250,000 = $200,000).

Couples who are married and file taxes jointly can sell their main residence and exclude up to $500,000 of the gain from the sale from their gross income. Single individuals can exclude only $250,000. Surviving spouses get the full $500,000 exclusion if they sell their house within two years of the date of the spouse’s death, and if other ownership and use requirements have been met. The result is that widows or widowers who sell within two years may not have to pay any capital gains tax on the sale of the home.

If it has been more than two years after the spouse’s death, the surviving spouse can exclude only $250,000 of capital gains. However, the surviving spouse does not automatically owe taxes on the rest of any gain.

When a property owner dies, the cost basis of the property is “stepped up.” This means the current value of the property becomes the basis. When a joint owner dies, half of the value of the property is stepped up. For example, suppose a husband and wife buy property for $200,000, and then the husband dies when the property has a fair market value of $300,000. The new cost basis of the property for the wife will be $250,000 ($100,000 for the wife’s original 50 percent interest and $150,000 for the other half passed to her at the husband’s death). In community property states, where property acquired during marriage is the community property of both spouses, the property’s entire basis is stepped up when one spouse dies.

To understand the tax consequences of selling property after the death of a spouse, contact your attorney.

You Can Stretch the Gift Tax Limit by Paying for Education or Health Care

If you want to make a gift to family members but have exceeded the annual gifting limit, there is another way. Payments for a family member’s education or health care expenses are exempt from the gift tax.

The annual gift tax exclusion for 2020 and 2021 is $15,000. This means that any person who gave away $15,000 or less to any one individual does not have to report the gift or gifts to the IRS. Any person who gave away more than $15,000 to any one person (other than their spouse) is technically required to file a Form 709, the gift tax return.

One way for a gift to be exempted from reporting requirements, no matter the gift’s size, is to pay for someone else’s medical care or educational tuition. A payment to a school must be made directly to the school (schools include not just colleges but nursery schools, private grade schools, or private high schools). The payment must be for tuition only–it cannot cover room and board or books. Pre-payments can often be made as soon as the person is admitted to the school. However, if you contribute to someone else’s 529 college savings plan, you are subject to the $15,000 gift exclusion rule. A special regulation in the tax code enables a donor to use up five years’ worth of exclusions and gift $75,000 (in 2021) to a 529 at one time.

With regard to medical expenses, the payment must be made directly to the health care provider or to a company that provides medical insurance. You can pay for the diagnosis, cure, mitigation, treatment or prevention of disease. In some circumstances, you may also be able to pay for transportation or lodging for the person seeking medical care. If the person is reimbursed by medical insurance for the care, the payment is not exempt from the annual gifting limit.

To find out the best way to provide for your loved ones without paying gift taxes, talk to your attorney.

 

How Your Estate Is Taxed, or Not

Congress sets the amount that an individual can transfer tax-free either during life or at death. The current estate tax exemption is so high that very few estates will have to pay an estate tax.

In 2017, Republicans in Congress and President Trump doubled the federal estate tax exemption and indexed it for inflation. In 2021, the exemption is $11.7 million for individuals and $23.4 million for couples. That means that as long as your estate is valued at under the exemption amount, it will not pay any federal estate taxes. The lifetime gift tax exclusion – the amount you can give away without incurring a tax – is also $11.7 million.  But you can still give any number of other people $15,000 each per year (in 2021) without the gifts counting against the lifetime limit. In 2026, the exemption is set to drop back down to the previous exemption amount of $5.49 million (adjusted for inflation).

The gift and estate tax rate is 40 percent. This means that if you transfer more than $11.7 million either during your life or upon your death, your estate will be taxed at 40 percent.

In addition, spouses can leave any amount of property to their spouses, if the spouses are U.S. citizens, free of federal estate tax. The estate tax exemption is also “portable” between spouses. This means that if the first spouse to die does not use all of his or her $11.7 million exemption, the estate of the surviving spouse may use it. So, for example, let’s say John dies in 2021 and passes on $10 million. He has no taxable estate and his wife, Mary, can pass on $13.4 million (her own $11.7 million exclusion plus her husband’s unused $1.7 million exclusion) free of federal tax. (However, to take advantage of this Mary must make an “election” on John’s estate tax return. Check with your attorney.)

The currently high federal estate tax exemption, coupled with the portability feature, might suggest that “credit shelter trusts” (also called AB trusts) and other forms of estate tax planning are needless for other than multi-millionaires, but there are still reasons for those of more modest means to have a trust or do other planning, and one of the main ones is state taxes. Slightly less than half the states also have an estate or inheritance tax and, in most cases, the thresholds are far lower than the current federal one.

Making Gifts: The $15,000 Rule

One simple way you can reduce estate taxes or shelter assets in order to achieve Medicaid eligibility is to give some or all of your estate to your children (or anyone else) during their lives in the form of gifts. Certain rules apply, however. There is no actual limit on how much you may give during your lifetime. But if you give any individual more than $15,000 (in 2021), you must file a gift tax return reporting the gift to the IRS. Also, the amount above $15,000 will be counted against a lifetime tax exclusion for gifts. This exclusion was $1 million for many years but is now $11.7 million (in 2021). Each dollar of gift above that threshold reduces the amount that can be transferred tax-free in your estate.

The $15,000 figure is an exclusion from the gift tax reporting requirement. You may give $15,000 to each of your children, their spouses, and your grandchildren (or to anyone else you choose) each year without reporting these gifts to the IRS. In addition, if you’re married, your spouse can duplicate these gifts. For example, a married couple with four children could give away up to $120,000 to their children in 2021 with no gift tax implications. In addition, the gifts will not count as taxable income to your children (although the earnings on the gifts, if they are invested, will be taxed).

Charitable Gift Annuities

Another way to remove assets from an estate is to make a contribution to a charitable gift annuity (CGA). A CGA enables you to transfer cash or marketable securities to a charitable organization or foundation in exchange for an income tax deduction and the organization’s promise to make fixed annual payments to you (and to a second beneficiary, if you choose) for life. A portion of the income will be tax-free.

The New Tax Law Means It’s Time to Review Your Estate Plan

While the new tax law doubled the federal estate tax exemption, meaning the vast majority of estates will not have to pay any federal estate tax, it doesn’t mean you should ignore its impact on your estate plan.

In December 2017, Republicans in Congress and President Trump increased the federal estate tax exemption to $11.18 million for individuals and $22.36 million for couples, indexed for inflation. (For 2019, the figures are $11.4 million and $22.8 million, respectively.) The tax rate for those few estates subject to taxation is 40 percent.

While most estates won’t be subject to the federal estate tax, you should review your estate plan to make sure the changes won’t have other negative consequences or to see if there is a better way to pass on your assets. One common estate planning technique when the estate tax exemption was smaller was to leave everything that could pass free of the estate tax to the decedent’s children and the rest to the spouse. If you still have that provision in your will, your kids could inherit your entire estate while your spouse would be disinherited.

For example, as recently as 2001 the federal estate tax exemption was a mere $675,000. Someone with, say, an $800,000 estate who hasn’t changed their estate plan since then could see the entire estate go to their children and none to their spouse.

Another consideration is how the new tax law might affect capital gains taxes. When someone inherits property, such as a house or stocks, the property is usually worth more than it was when the original owner purchased it. If the beneficiary were to sell the property, there could be huge capital gains taxes. Fortunately, when someone inherits property, the property’s tax basis is “stepped up,” which means the tax basis would be the current value of the property. If the same property is gifted, there is no “step up” in basis, so the gift recipient would have to pay capital gains taxes. Previously, in order to avoid the estate tax you might have given property to your children or to a trust, even though there would be capital gains consequences. Now, it might be better for your beneficiaries to inherit the property.

In addition, many states have their own estate tax laws with much lower exemptions, so it is important to consult with your attorney to make sure your estate plan still works for you.

IRS Issues Long-Term Care Premium Deductibility Limits for 2019

The Internal Revenue Service (IRS) is increasing the amount taxpayers can deduct from their 2019 income as a result of buying long-term care insurance.

Premiums for “qualified” long-term care insurance policies (see explanation below) are tax deductible to the extent that they, along with other unreimbursed medical expenses (including Medicare premiums), exceed 7.5 percent of the insured’s adjusted gross income.  (The 7.5 percent threshold is for the 2017 and 2018 tax years.  It is scheduled to revert to 10 percent in 2019.)

These premiums — what the policyholder pays the insurance company to keep the policy in force — are deductible for the taxpayer, his or her spouse and other dependents. (If you are self-employed, the tax-deductibility rules are a little different: You can take the amount of the premium as a deduction as long as you made a net profit; your medical expenses do not have to exceed a certain percentage of your income.)

However, there is a limit on how large a premium can be deducted, depending on the age of the taxpayer at the end of the year. Following are the deductibility limits for 2019. Any premium amounts for the year above these limits are not considered to be a medical expense.

Attained age before the close of the taxable year Maximum deduction for year
40 or less $420
More than 40 but not more than 50 $790
More than 50 but not more than 60 $1,580
More than 60 but not more than 70 $4,220
More than 70 $5,270

Another change announced by the IRS involves benefits from per diem or indemnity policies, which pay a predetermined amount each day.  These benefits are not included in income except amounts that exceed the beneficiary’s total qualified long-term care expenses or $370 per day, whichever is greater.

For these and other inflation adjustments from the IRS, click here.

What Is a “Qualified” Policy?

To be “qualified,” policies issued on or after January 1, 1997, must adhere to certain requirements, among them that the policy must offer the consumer the options of “inflation” and “nonforfeiture” protection, although the consumer can choose not to purchase these features. Policies purchased before January 1, 1997, will be grandfathered and treated as “qualified” as long as they have been approved by the insurance commissioner of the state in which they are sold.

How Will the New Tax Law Affect You?

While most of the new tax law – the Tax Cuts and Jobs Act – has to do with reducing the corporate tax rate from 35 percent to 21 percent, some provisions relate to individual taxpayers. Before we get into the details, be aware that almost everything listed below sunsets after 2025, with the tax structure reverting to its current form in 2026 unless Congress acts between now and then. The corporate tax rate cut, however, does not sunset. Here are the highlights for our readership:

  • Estate Taxes.If you weren’t worried about federal estate taxes before, you really don’t need to worry now. With the federal exemption already scheduled to increase in 2018 to $5.6 million for individuals and $11.2 million for couples, the Republicans in Congress and President Trump have now nearly doubled this to $11.18 million (estimate) and $22.36 million (estimate), respectively, indexed for inflation. The tax rate for those few estates subject to taxation remains at 40 percent.
  • Tax Rates. These are slightly reduced and the brackets adjusted, with the top bracket dropping from 39.6 percent to 37 percent.
  • Standard Deduction and Personal Exemption. The standard deduction increases to $12,000 for individuals, $18,000 for heads of household and $24,000 for joint filers, all adjusted for inflation. Personal exemptions largely disappear.
  • State and Local Tax Deduction. Now referred to as “SALT,” this is now subject to a cap of $10,000,
  • Home Mortgage Interest Deduction. The limit on deducting interest on up to $1 million of mortgage interest stays in effect for existing mortgages. New mortgages taken on after December 15, 2017, are subject to a $750,000 limit. The deduction for interest on home equity loans disappears.
  • Medical Expense Deduction. After much outcry in response to the House version of the tax bill, which would have eliminated the medical expense deduction, it survived. And, in fact, it was enhanced by permitting medical expenses in excess of 7.5 percent of adjusted gross income to be deducted in 2017 and 2018, after which it reverts to the 10 percent under existing law.
  • 529 Plans. These accounts permitting tax-free accumulation of capital gains and dividends to pay college expenses can now be used for private school tuition of up to $10,000 a year.

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