Estate Planning: Learn How the 'Step-Up Basis' Tax Rules Work and Reduce Taxes on Capital Gains

Traditionally, estate planning has focused on reduction of estate tax and avoiding probate. The maximum income tax rates for California residents is 57.1% for ordinary investment income and 37.1% for capital gains. With the current $5.45 million estate tax exemption, fewer than .2% of the US population pays estate tax. However, we all pay income tax and minimizing the capital gains tax is more important than ever before. Understanding the concepts and mechanics of basis for income tax purposes is the key to minimizing capital gains.

New Requirement for Executors In 2015, a law was passed that requires, under certain circumstances, an executor to provide a statement identifying the fair market value of certain inherited property to the individual receiving that property. This requirement applies to executors who must file a federal estate tax return.

The Basics of Basis

The basis of property you buy is usually its cost. It also includes amounts you pay for items including sales tax, freight, commissions and transfer fees.

The basis of property inherited from a decedent is generally one of the following:

• The fair market value (FMV) of the property at the date of the individual's death.
• The FMV on the alternate valuation date if the executor or personal representative for the estate chooses to use alternate valuation.

There are special valuation methods and rules for real property used in farming, closely held businesses and qualified conservation easements.

Step Up, Step Down

Under the fair market value basis rules (also known as the "step-up and step-down" rules), the heir receives a basis in inherited property equal to its date of death value. So, for example, if your grandfather bought Kodak stock in 1935 for $500 and it's worth $5 million at his death, the basis is stepped up to $5 million in the hands of his heirs and all of that gain escapes income taxation forever.

The fair market value basis rules apply to inherited property that's includible in the deceased's gross estate, whether or not a federal estate tax return was filed. Those rules also apply to property inherited from foreign persons, who aren't subject to U.S. estate tax. The rules apply to the inherited portion of property owned by the inheriting taxpayer jointly with the deceased, but not the portion of jointly held property that the inheriting taxpayer owned before his inheritance. The fair market value basis rules also don't apply to reinvestments of estate assets by fiduciaries.

It's crucial for the fair market value basis rules to be understood so that disastrous tax errors aren't made.

For example, in the above example, if your grandfather, instead of dying owning the stock, decided to make a gift of it in honor of his 100th birthday, the "step-up" in basis (from $500 to $5 million) would be lost. Property that has gone up in value acquired by gift is subject to the "carryover" basis rules: The donee takes the same basis the donor had in it (just $500), plus a portion of any gift tax the donor pays.

A "step-down," instead of a "step-up," occurs if a decedent dies owning property that has declined in value. In that case the basis is lowered to the date of death value. Proper planning calls for seeking to avoid this loss of basis. In this case, however, giving the property away before death will not preserve the basis: When property which has gone down in value is the subject of a gift, the donee must take the date of gift value as his or her basis (for purposes of determining his loss on a later sale). The best idea for property which has declined in value, therefore, is for the owner to sell it before death so he can enjoy the tax benefits of the loss.

Note also that a basis step-down may be avoided in an Optimum Basis and Income Tax Efficiency Trust utilizing upstream planning as described below.

Although the above discussion refers to the date of death value, the value is different in some cases. Where the decedent's executor makes the alternate valuation election, then basis will be determined as of the date six months after the date of death (or, if the property is distributed or otherwise disposed of by the estate within the six month period, the date of distribution or other disposition).

Deathbed Maneuvers

One strategy considered by some taxpayers is to pass property through a decedent to attempt to inflate basis under the fair market value basis rules.

For example, let's say you own stock with a $1,000 basis and $20,000 value. You go to your 97-year-old grandmother and arrange the following: You make a gift of the stock to your grandmother, who takes it with your $1,000 basis. Then, your grandmother dies leaving the stock back to you in her will. You regain ownership, but now with the basis stepped up to its $20,000 date of death value. However, under a rule to prevent this result, if your grandmother dies within a year of when you made the gift, you still have your original ($1,000) basis. The result is the same if, instead of leaving the stock to you, your grandmother leaves the stock to your spouse.

Contact your our firm if you need more information about the basis of assets in your estate. Planning ahead can make a big difference in the amount that heirs eventually receive.

The Optimum Basis and Income Tax Efficiency Trust

With the high estate tax exemption, very few people need a bypass trust (also known as the credit exemption trust or the "B" trust) to avoid estate tax. A B style trust may be desired for other reasons such as greater asset protection or to provide for children from a prior marriage. An Optimum Basis and Tax Efficiency Trust (the "OBIT") can be used to maximize the basis step-up to reduce capital gains, avoid a basis step-down if the economy falters and property values fall and even provide for upstream planning to get a basis step-up upon the death of an older relative such as a father or mother-in-law.