“Tax basis” is a term used frequently in tax law. But for many, the term is unfamiliar and intimidating—perhaps something they feel is better left to a certified public accountant to worry about.
Nevertheless, a basic understanding of the concept can be very helpful for understanding important estate planning strategies used by your attorney and financial or tax advisors.
So, what is tax basis, and why is it important to be familiar with the term, particularly as it relates to your taxes and estate planning?
A technical definition of tax basis is “the value assigned to a taxpayer’s investment in property and used primarily for computing gain or loss from a transfer of the property. When the assigned value represents the cost of acquiring the property, it is also called cost basis.”[1]
A simple example illustrates how tax basis is used in everyday situations: Imagine that you purchased one acre of unimproved land in 1990 for $10,000 and still own it. Generally speaking, this land’s tax basis is $10,000, the amount you paid for it. Imagine further that you decide to sell the property in 2021, and a neighbor has offered to pay you $100,000 for it. Upon investigation, you determine that your neighbor’s offer is reasonable, so you accept the offer. Your profit (or gain) on your investment is $90,000. This is the amount that you must report to the Internal Revenue Service and your state tax authorities as capital gains on your 2021 income tax returns and that is typically subject to federal, and possibly state, capital gains taxes.
State capital gains tax rates vary from state to state, and federal capital gains tax rates range from 0-20 percent, depending on a variety of factors associated with the forms and amounts of your other income.[2]
On the other side of the tax equation, it is important to establish the tax basis of investments even when the value of your investment has dipped below the amount you paid. If you sell your property for a price below its tax basis, you may be able to report capital losses that can be used to offset capital gains realized on other assets that were sold. If you are actively buying and selling investments, your tax advisor is the person best suited to help you determine how to manage your capital gains and losses to achieve the best tax results available from year to year.
What is stepped-up tax basis?
Stepped-up tax basis is a very important tax concept for estate and tax planning purposes. Section 1014 of the United States Code provides that a person who inherits property that was included in the decedent’s estate obtains a new tax basis for the property that is equal to the fair market value of the property as of the decedent’s date of death.[3] Therefore, an individual who inherits property can sell it and pay little to no capital gains taxes, resulting in significant tax savings for families who intend to pass on highly appreciated property such as land, company stock, or a family business instead of selling or gifting it during their lifetimes.
Continuing with the example described above, if you leave your one acre of land to your only child in your will or trust, their tax basis in that property at your death will be $100,000 (assuming that amount is the fair market value as determined by a qualified appraisal). If your child were to turn around and sell the property for cash the day after you die, there would likely be no additional capital gains because of the short time between your death and the sale of the property and, therefore, no capital gains taxes due.
What is carry-over tax basis?
A different tax basis rule applies to property that is transferred as a lifetime gift from the property owner directly to an individual or to an irrevocable trust for the benefit of another person.[4] This rule results in what is called “carry-over” tax basis, meaning that the gift recipient’s basis is the same as the giver’s tax basis.
In our example above, if you deed your property to your child before you die (or if you make an irrevocable gift of the property to a trust for the benefit of someone other than yourself), the basis for that property remains the same as it was when you owned it ($10,000). This is important to remember because, even if your child holds onto that property for years after you die and then decides to sell it, they will still have your tax basis in the property. So, assuming they sell it for a price greater than the basis, they will probably end up paying significantly more capital gains taxes than would be due if they had inherited the property as a result of your death.
This is not to say that it never makes sense to give away property during your lifetime. In some cases, such as when certain property is appreciating rapidly or your estate is large enough to be exposed to estate taxes, it could very well be wise to transfer property out of your estate to avoid the 40 percent estate tax on property that will pass to your beneficiaries or heirs without being sheltered by the estate tax exemption at your death.
Why are people talking about basis right now?
The Biden administration has been openly exploring the idea of eliminating the step-up in tax basis rule, or at least modifying it significantly, in an effort to increase tax revenues on property passing from generation to generation.[5] If this proposed legislation becomes law, the estate planning landscape will change dramatically, creating a need for many individuals and families to revisit their planning with their legal and tax professionals.
Should you be worried?
It is too early to tell whether President Biden has the political capital to be able to push such an impactful tax law change through Congress. He will almost certainly receive stiff opposition from Republicans and perhaps also from a number of moderate Democrats. The jury is still out on how likely it is that this change will be implemented. If President Biden is successful, however, rest assured that tax and estate planning advisors will be working overtime to find creative and effective tax-minimization solutions for their clients. Although the future may be uncertain, at Davis Law Group we are committed to keeping you informed about the changing landscape. Contact Us if you have any questions about how we can help you prepare for the uncertain future.
[5]See The White House, Fact Sheet: The American Families Plan 14 (Apr. 28, 2021), https://www.whitehouse.gov/wp-content/uploads/2021/04/American-Families-Plan-Fact-Sheet-FINAL.pdf
Tax Basis: What You Need to Know and How It Can Impact Your Estate
“Tax basis” is a term used frequently in tax law. But for many, the term is unfamiliar and intimidating—perhaps something they feel is better left to a certified public accountant to worry about.
Nevertheless, a basic understanding of the concept can be very helpful for understanding important estate planning strategies used by your attorney and financial or tax advisors.
So, what is tax basis, and why is it important to be familiar with the term, particularly as it relates to your taxes and estate planning?
A technical definition of tax basis is “the value assigned to a taxpayer’s investment in property and used primarily for computing gain or loss from a transfer of the property. When the assigned value represents the cost of acquiring the property, it is also called cost basis.”[1]
A simple example illustrates how tax basis is used in everyday situations: Imagine that you purchased one acre of unimproved land in 1990 for $10,000 and still own it. Generally speaking, this land’s tax basis is $10,000, the amount you paid for it. Imagine further that you decide to sell the property in 2021, and a neighbor has offered to pay you $100,000 for it. Upon investigation, you determine that your neighbor’s offer is reasonable, so you accept the offer. Your profit (or gain) on your investment is $90,000. This is the amount that you must report to the Internal Revenue Service and your state tax authorities as capital gains on your 2021 income tax returns and that is typically subject to federal, and possibly state, capital gains taxes.
State capital gains tax rates vary from state to state, and federal capital gains tax rates range from 0-20 percent, depending on a variety of factors associated with the forms and amounts of your other income.[2]
On the other side of the tax equation, it is important to establish the tax basis of investments even when the value of your investment has dipped below the amount you paid. If you sell your property for a price below its tax basis, you may be able to report capital losses that can be used to offset capital gains realized on other assets that were sold. If you are actively buying and selling investments, your tax advisor is the person best suited to help you determine how to manage your capital gains and losses to achieve the best tax results available from year to year.
What is stepped-up tax basis?
Stepped-up tax basis is a very important tax concept for estate and tax planning purposes. Section 1014 of the United States Code provides that a person who inherits property that was included in the decedent’s estate obtains a new tax basis for the property that is equal to the fair market value of the property as of the decedent’s date of death.[3] Therefore, an individual who inherits property can sell it and pay little to no capital gains taxes, resulting in significant tax savings for families who intend to pass on highly appreciated property such as land, company stock, or a family business instead of selling or gifting it during their lifetimes.
Continuing with the example described above, if you leave your one acre of land to your only child in your will or trust, their tax basis in that property at your death will be $100,000 (assuming that amount is the fair market value as determined by a qualified appraisal). If your child were to turn around and sell the property for cash the day after you die, there would likely be no additional capital gains because of the short time between your death and the sale of the property and, therefore, no capital gains taxes due.
What is carry-over tax basis?
A different tax basis rule applies to property that is transferred as a lifetime gift from the property owner directly to an individual or to an irrevocable trust for the benefit of another person.[4] This rule results in what is called “carry-over” tax basis, meaning that the gift recipient’s basis is the same as the giver’s tax basis.
In our example above, if you deed your property to your child before you die (or if you make an irrevocable gift of the property to a trust for the benefit of someone other than yourself), the basis for that property remains the same as it was when you owned it ($10,000). This is important to remember because, even if your child holds onto that property for years after you die and then decides to sell it, they will still have your tax basis in the property. So, assuming they sell it for a price greater than the basis, they will probably end up paying significantly more capital gains taxes than would be due if they had inherited the property as a result of your death.
This is not to say that it never makes sense to give away property during your lifetime. In some cases, such as when certain property is appreciating rapidly or your estate is large enough to be exposed to estate taxes, it could very well be wise to transfer property out of your estate to avoid the 40 percent estate tax on property that will pass to your beneficiaries or heirs without being sheltered by the estate tax exemption at your death.
Why are people talking about basis right now?
The Biden administration has been openly exploring the idea of eliminating the step-up in tax basis rule, or at least modifying it significantly, in an effort to increase tax revenues on property passing from generation to generation.[5] If this proposed legislation becomes law, the estate planning landscape will change dramatically, creating a need for many individuals and families to revisit their planning with their legal and tax professionals.
Should you be worried?
It is too early to tell whether President Biden has the political capital to be able to push such an impactful tax law change through Congress. He will almost certainly receive stiff opposition from Republicans and perhaps also from a number of moderate Democrats. The jury is still out on how likely it is that this change will be implemented. If President Biden is successful, however, rest assured that tax and estate planning advisors will be working overtime to find creative and effective tax-minimization solutions for their clients. Although the future may be uncertain, at Davis Law Group we are committed to keeping you informed about the changing landscape. Contact Us if you have any questions about how we can help you prepare for the uncertain future.
[1] Basis, Black’s Law Dictionary (8th ed. 2004).
[2] See, e.g., Internal Revenue Service, Topic No. 560 Additional Medicare Tax, https://www.irs.gov/taxtopics/tc560 (last visited June 21, 2021).
[3] I.R.C. § 1014.
[4] Id. § 1015.
[5] See The White House, Fact Sheet: The American Families Plan 14 (Apr. 28, 2021), https://www.whitehouse.gov/wp-content/uploads/2021/04/American-Families-Plan-Fact-Sheet-FINAL.pdf
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