As we’ve made clear in prior posts, one of the primary objectives of estate planning is to ensure that as many of your hard-earned assets as possible are transferred to your loved ones upon your passing, such that that the federal government’s tax interest is effectively minimized.
Interestingly enough, experts indicate that in their haste to minimize estate taxes, many people are actually overlooking a very effective strategy that requires no greater effort than simply letting loved ones inherit valuable assets upon their death such that they can utilize what is known as a step-up in basis.
In general, the tax term “basis” refers to the amount of money that a person paid for an asset like a home or stock. Internal Revenue Service regulations dictate that if a person proceeds to turn around and sell an asset for a profit, they’ve realized what is known as a capital gain and will need to pay taxes on the earnings.
By way of illustration, consider a person who bought company stock several decades ago for $20 per share (the basis) and sold it this week for $100 per share. Here, they would be required to pay taxes on the $80 per share capital gain (with their tax rate ranging from 0 percent to 23.8 percent depending on their income).
While it’s plainly evident how these capital gains taxes can prove to be rather onerous, they can actually be avoided if an owner allows their heirs to inherit the asset, which, in turn, will step up the cost basis to the value on the date of their passing.
By way of another illustration, consider an elderly mother who leaves her adult children stock in the company for which she worked all her life that was valued at $100,000 on the date of her passing and the cost basis of which was a mere $10,000.
Thanks to the step-up in basis, her adult children will not have to pay capital gains tax on the $90,000 in gains.
Furthermore, the adult children will only be responsible for paying capital gains tax on profits realized after they inherit the stock, such that if they later sell the $100,000 in stock for $150,000, they would pay capital gains tax on the $50,000, the post-inheritance value increase.
As to when the step-up in basis is forfeited, experts indicate that it frequently happens when people decide to gift an asset in order to save a moderate amount of estate tax rather than holding onto it until their death.
We’ll continue discussing this complex issue in our next post, exploring circumstances in which it may still be preferable to execute a trust rather than simply relying on inheritance or vice versa.
If you have questions or concerns relating to an estate planning matter, please consider speaking with a skilled legal professional who can answer your questions, outline your options and help you pursue solutions.