For many years, the focus for estate planning was minimizing estate tax. The higher estate tax credits and the potential for estate tax repeal creates a need to now focus on income tax planning. Income tax requires an understanding of basis planning.
First, let's start with what "basis" means. Your basis is usually what you paid for an asset. According to the IRS, a capital gain or loss is the difference between your basis and the amount you get when you sell an asset. There can be adjustments to that basis amount, such as increases for improvements and decreases for depreciation expenses that are taken or allowable. So, if you sell an asset that is worth more than you paid for it, you will have to pay taxes on the gain.
If for example, you had purchased stock many years ago for $10 a share and you sold it today for $75 a share, the $65-per-share gain would have to be taxed. These capital gains taxes will vary depending on whether they are considered short-term gains (assets held for less than one year and taxed as ordinary income) or long-term gains (assets held for more than one year and taxed for federal income tax purposes are between 0 percent and 23.8 percent, depending on your income level). The maximum combined rate (the Federal and California rates combined) for California residents is 37.1%.
While capital gains taxes can be significant, the government gives heirs a break when they inherit appreciated assets. When someone inherits an asset, the cost basis of the asset is "stepped up to value" on the date of death.
Let's assume that an elderly parent leaves a home to her grown children. The home was purchased 25 years ago for $100,000 — the original basis — and is valued at $400,000 on the date of death. While the beneficiaries may have to pay estate or inheritance taxes depending on the size of the estate, they will not be responsible for capital gains tax on $300,000 worth of gains if they decide to sell the house. The government immediately resets that $100,000 basis to $400,000.
Since they received a step-up in basis, they will be responsible only for gains that might occur from the point at which they inherit the asset and then sell it. So if the beneficiaries later sell the home for $425,000, only the $25,000 is considered a gain as it represents the increase in value after the original owner passed away.
Now that you know about this, you should examine the cost basis of assets before you think of gifting as the preferred means of transferring wealth.
Estate planning attorneys note that too often an emphasis is made on gift-giving to avoid a modest amount of estate tax, because then the recipient of the gift is confronted with a large capital gain to be paid when selling the gifted item. Holding the property rather than gifting it to the beneficiary could relieve that beneficiary of any capital gains tax if there is no additional gain on the value of the property. It's a good idea to consider this for any highly appreciated property, as gifting could result in capital gains taxes that could have been avoided.
There are also special situations resulting in a half-step-up in basis that can apply to certain situations: When assets are owned by joint tenants with rights of survivorship between spouses and one spouse passes away, a partial increase in basis may apply.
So let's say that stock owned jointly with rights of survivorship was originally purchased for $50,000 and is worth $100,000 on the date one spouse passes away. The new basis for the surviving spouse would be equal to the fair market value on the date of death plus the original basis divided by two, or $100,000 + 50,000 / 2 = $75,000. In this way, half of the assets receive a stepped-up basis. This is a disaster for a married couple.
A married couple in California should never own assets in joint tenancy. This is a common mistake as it prevents the surviving spouse from obtaining a full step-up in basis for income tax purposes. This problem was so bad that the State of California created a new form of ownership solely to prevent this income tax issue from arising for its residents. A better approach for holding title as a married couple is "community property with the right of survivorship". This provides ease of transfer to the survivor spouse but also provides for a full step-up in basis for income tax purposes. Better still, use a trust for ownership of assets which also provides for the transfer to children or their heirs. Remember, a full step-up in income tax basis really means lower capital gains tax.
Using a step-up in basis can lead to big tax savings, but there are limitations to consider. It doesn't apply to assets held jointly with children. Also, you can't use it for tax-deferred accounts such as IRAs or 401(k)s.
Note that these concepts will change if the federal estate tax is in fact repealed. The repeal of the federal estate tax provides a significant benefit for only 0.2% of the general public (in the United States). However, the loss of the step-up in income tax basis subjects us all to higher taxes on capital gains.
Optimizing an estate plan to minimize inheritance, estate and capital gains taxes is no easy task. Complexities in the tax code certainly don't make it easy for the average person to address these issues. Your situation is unique, and that's why you may want to consider speaking to a certified specialist in order to identify and implement the most appropriate planning approach for you. Speak with a professional before making a major decision.