As a general rule, disposing of an asset that has appreciated in value triggers a tax obligation to the Internal Revenue Service (IRS). If you have held the asset for less than a year, you will owe ordinary income tax; if you have held it for a year or longer, you will pay the capital gains rate (currently 15 or 20 percent for most Americans).
The amount of tax you owe is calculated based on the difference between the original purchase price (known as the “basis”) and the amount realized upon disposition (i.e., the sales price). In other words, you do not owe tax on the entire amount you receive upon sale, but only on the income earned as a result of the asset’s appreciation. Still, when an asset has appreciated substantially over time, the tax bill upon disposition can be substantial. For example, if you bought 100 shares of Google stock during the company’s initial public offering (at $85 per share) and sold them at the current market price of over $1,000 per share, at the maximum capital gains rate of 20 percent you would be facing a tax bill somewhere in the range of $19,000. That is no small amount of money!
How a Stepped-Up Basis Can Protect Your Children’s Inheritance
Transferring an asset at death is another “disposition” that can potentially trigger federal tax liability. However, there is a special rule that limits beneficiaries’ tax burden when gifts from the estate are structured appropriately. For appropriately-structured transfers upon death, beneficiaries receive a “stepped-up basis,” which means that any gains are calculated based on the asset’s value on the date of death instead of the date of original purchase.
Returning to the Google stock example, without the step-up basis rule, if your estate plan calls for your shares to be distributed to one of your children upon your death, your death would trigger a $19,000 tax liability. This would be the case regardless of whether your child held onto the shares or sold them; and, without $19,000 in liquidity, your child may be forced to sell the shares just to meet his or her tax obligations. But, with the step-up basis rule, upon your death, your child’s basis in the shares automatically increases to the current market value. As a result, (i) no tax is owed at the time of death; and, (ii) any future tax obligations will be calculated based on your child’s stepped-up basis in the shares.
How Can You Ensure that Your Children Will Receive a Stepped-Up Basis?
As you can see, the tax savings from the step-up basis rule can be substantial. So, how can you ensure that your children will not face unnecessary tax liability triggered by your death? Here are some general recommendations:
1. Avoid Non-Strategic Use of Lifetime Gifts
While making gifts during your lifetime can help your loved ones avoid estate tax liability (if the value of your estate exceeds the exemption threshold), as a general rule, lifetime gifts are not eligible for step-up basis protection. So, by avoiding estate tax, you may be subjecting your loved one to income tax or capital gains tax liability.
While this may still be a beneficial solution (since the estate tax rate is currently slightly higher than the highest income tax rate and double the maximum capital gains rate), it will not always be the best solution available. When structuring lifetime gifts, it is important to keep basis in mind, and to consider gifting assets that do not have basis-related tax implications. That way, you can preserve the benefit of the step-up basis rule while also taking advantage of the annual gift tax exclusion.
2. Make Effective Use of Trusts
For most people, making effective use of trusts is a core component of the estate planning process. When estate planning with trusts, it is possible to retain the stepped-up basis benefit for appreciated assets even when those assets become trust property. However, mistakes with trusts can have significant financial consequences, and individuals seeking to use trusts to transfer appreciated assets must plan their estates accordingly.
For example, consider the use of an “A/B trust” to transfer the family home to a couple’s children after both spouses’ deaths. Let’s suppose a 50/50 split between the surviving spouse and the children at the time of the first spouse’s death. When the first spouse dies, half of the ownership interest in the home will be transferred into an irrevocable trust for the benefit of the children. This triggers a step-up in basis for the children’s interest in the home. Assuming the home continues to appreciate in value, the children will lose out on the additional step-up in basis for this initial one-half interest when they receive full ownership of the home upon the second spouse’s death. This is a costly mistake – and an avoidable one – and it demonstrates the type of long-term thinking required to effectively minimize the tax implications of a complex estate plan.
3. Avoid Holding Appreciated Assets in C-Corporations
In some circumstances, it can make sense to use limited liability companies (LLCs) and corporations for estate planning purposes. However, while real estate held in an LLC receives a stepped-up basis at the time of death, the same is not true for properties held in a C-corporation. Beneficiaries receive a stepped-up basis in their newly-acquired corporate shares, but not in the assets owned by the corporation.
4. Avoid Joint Ownership Prior to Death
While it may seem like a good idea to jointly own appreciated assets that you intend to transfer at death (and many resources you find online will recommend this approach), doing so eliminates the tax benefits of the step-up basis rule. When you jointly own assets with someone who is entitled to sole ownership upon your passing, at most, your joint owner will receive a stepped-up basis in only your portion of the asset. If your respective ownership interests are indivisible, the step-up basis rule may not apply at all.
5. Hold on to Your Appreciated Assets
If you sell appreciated assets before you die, you will be liable for income or capital gains tax. Prior to disposing of appreciated assets during your lifetime, it is important to consider the tax consequences as well as the various potential alternatives that may be available.
While the step-up basis rule can provide substantial savings, it is important to remember that it is still just one of numerous factors that should influence the overall structure of your estate plan. During the estate planning process, no benefits should be considered to the exclusion of any other, and estate planning decisions should be made with due consideration for all of the relevant factors involved. At Jiah Kim & Associates, we provide comprehensive estate planning services for US residents and expats, and we can help you make informed decisions that maximize wealth for future generations.
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If you would like to speak with an experienced estate planning attorney, we invite you to contact us for an initial consultation. You can schedule an appointment online, or call us at (646) 389-5065 to speak with a member of our firm today.
This blog post is written for educational and general information purposes only, and does not constitute specific legal advice. You understand that there is no attorney-client relationship between you and the blog publisher. This blog should not be used as a substitute for competent legal advice from a licensed professional attorney in your state.