Volume 8, Issue 3
The Wealth Advisor
Warning: What You Don’t Know About Income Tax Basis Could Hit Your Bottom Line
Income tax basis may not be the most exciting topic to read about. However, it is a critically important topic to anyone who owns significant assets. Gaining an understanding of the basics of basis is a way to avoid costly mistakes.
The Real Meaning of Basis
In plain English, basis means the cost you paid for an asset, plus any amount you paid to improve the asset, less any deductions you have taken against the asset. This means that your basis is used to determine the amount of capital gain or loss to report on your income tax return when the asset is sold.
Lifetime Gifts: A Basis Disaster Waiting to Happen
Bottom line: Gifting low basis property during your lifetime may not be the most tax efficient way to place the property into your daughter’s hands. In the alternative, passing the property to your daughter after you die will give her a “step up” in basis to its fair market value as of the date of your death. This makes sense if your estate isn’t taxable for state or federal purposes and your heirs are likely to sell the inherited property shortly after your death instead of holding on to it for years into the future. Of course, you will have to consider whether your estate is likely to grow in value to become subject to estate tax at your death, or if there is any possibility that the estate tax exemption (presently $5,340,000) will become less significant in the future due to inflation or legislative action.
To avoid a basis disaster, if you’re considering gifting that low basis stock or house to your children or other beneficiaries, please contact us before you do.
AB Trusts – Do You Need to Get Rid of Yours?
For example, if Fred dies in 2014 and none of his $5.34 million exemption is used, then his wife, June, can add Fred’s $5.34 million exemption to her $5.34 million exemption so that June now has an exemption equal to $10.68 million. All property passing to June from Fred’s estate, revocable trust, or by right of survivorship will receive a full step up in basis to the fair market values as of Fred’s date of death. Subsequently, when June dies her beneficiaries receive a full, second step up in basis to the full fair market value as of June’s date of death.
Let’s consider another possibility. What if Fred and June have a typical 1990s estate plan, which uses “AB Trusts” (also called “Marital and Family Trusts” or “QTIP” and “Bypass Trusts”) to ensure full use of both spouses’ federal estate tax exemptions?
Back in 1999, the federal estate tax exemption was only $650,000. Using our scenario with Fred and June, if Fred and June were lax and neglected to update their estate plan and Fred dies in 2014, then not only will June be stuck with AB Trusts that were drafted using decades old planning priorities, but their heirs won’t receive a step up in basis for the assets remaining in the B Trust when June dies. Instead, they will inherit the B Trust assets with the basis calculated as of Fred’s 2014 date of death. In some cases, the lack of a step up for the B Trust assets may not make a big difference due to stagnant asset values or the enhanced asset protection opportunities that may be available for B Trust assets.
If you are married and your estate plan is more than a few years old, please give us a call so that together we can determine if an AB Trust plan still makes sense for you and your family. We may be able to revise your existing estate plan to take advantage of the good features of AB Trust planning while gaining the benefits of an additional step up in basis.
Beyond the Basics – Advanced Basis Planning Opportunities
The Bottom Line on Basis
Law Offices of J.R. Hastings • 1003 Third Street, San Rafael, California 94901 • 415-450-6692