23 August 2022

Estate Planning and Basis Adjustment at Death

What is basis?  Simply put, basis is the amount of capital you have invested in your assets, such as stocks, real estate and other investment property. In most cases, the basis of an asset is what it cost to you – the amount you paid for it in cash, debt obligations and other property or services.

Certain events can increase or decrease your basis. For example, your basis in property may increase when you make capital improvements that add value to that property.  Your basis may decrease when you take a depreciation deduction or receive insurance reimbursements.

When you sell, exchange or otherwise dispose of your property, your capital gain or loss is generally calculated on the difference between your sales price and your basis.   As a simplified example, if Alex purchases a stock for $100,000, his basis is $100,000. If he sells the stock for $190,000, his capital gain subject to tax is the purchase price minus the basis or $90,000.

There are special rules for determining basis for property that you did not acquire by purchase.  When you make a gift of property, the recipient gets a “carry over basis.”  The donor’s basis transfers to the donee.  If Alex purchases a stock for $100,000, and gifts it to his daughter when it is worth $190,000, her basis is $100,000.  If the stock had gone down in value to $50,000 at the time of the gift, her basis is still $100,000 because Alex’s basis carries over to her.

Basis Adjustments at death

Special basis rules apply when a person dies owning appreciated assets.  Note that these special rules don’t apply to land contracts, annuities or retirement plans.  These rules also may not apply to property held in trust for the benefit of a spouse or other beneficiary. Under the Internal Revenue Code, qualified appreciated assets get a basis adjustment when the owner dies.  The new basis of the asset is the generally equal to the fair market value of the asset at the person’s death.

This is often referred to as a “step up in basis at death.”  The step-up in basis can have significant tax advantages, particularly for property that has appreciated in value between the time the individual acquired the property and the date of their death.  For example, if Alex purchases stock for $100,000, and dies when the stock is worth $190,000, the new stepped up basis at his death is $190,000.  If his estate plan bequeaths the stock to his daughter, and she sells it for $200,000, her capital gain is the difference between the sales price of $200,000 and her basis of $190,000, that is $10,000.  She does not have to pay capital gains tax on the appreciation in value before her father’s death.

Particularly in today’s volatile economy, it is important to note that basis adjustments could result in a step down in basis.  The basis adjustment at death is equal to the fair market value as of the person’s death.  If the value of the property owned by the person who died had decreased since that person acquired it, the basis will be decreased.  For example, if Alex owned stock that he purchased for $100,000, but the stock was only worth $50,000 on the date of his death, the new stepped down basis is $50,000.  If his estate plan bequeaths this stock to his daughter and she sells if for $200,000, her capital gain is $150,000, that is, the difference between her basis of $50,000 and the sales price of $200,000.

It is important to note that community property states or those individuals with assets in community property trusts have different rules regarding basis adjustments at death. In some of these states, the rules provide for a step-up in basis on community property – all assets accumulated during marriage other than inheritances and gifts – for the surviving spouse. In other states, assets owned solely by the surviving spouse do not receive a step-up in basis, and jointly owned assets receive only half the step-up in basis they would receive in a community property state.

Estate Planning Opportunities to Reduce Tax Exposure  

  • Identify highly appreciated property that might be affected by a step up on basis at death
  • When possible, especially for older individuals, consider holding onto highly appreciated assets and selling them after the death of the original owner
  • Segregate community property from non-community property to take full advantage of its special character
  • Identify appreciated property held in trust for the benefit of a spouse or other beneficiary and determine whether there are strategies to qualify that property for a step up in basis. This might include terminating the trust, or determining whether a power of appointment may be added
  • Consider gifting property that has gone down in value during lifetime to avoid the step down in basis at death

Tax basis rules are complex and require tracking and documentation. You should consult your estate planning attorney and tax advisors to discuss opportunities for planning around tax basis.