When preparing your estate plan, you may have multiple goals. You want to provide for your loved ones. You may want to avoid probate, if at all possible. And you almost certainly want to avoid your heirs and beneficiaries having to pay unnecessary taxes. Unfortunately, in a misguided attempt to avoid the probate process or estate taxes, many people take steps that will result in their heirs paying increased income tax or capital gains tax. To avoid this outcome, it's important to understand the interaction of tax basis and your estate plan.
What exactly is tax basis? It's the value upon which the taxation of certain property is based. Often, your basis in certain property is the price you paid for it. Basis may be increased by improvements to the property, or decreased by depreciation taken against the property.
What does any of this have to do with your estate planning? More than you might expect. Depending on how and when you transfer property to your heirs, their property basis may be higher or lower. And the higher their basis, the less income tax or capital gains tax they will pay.
Your heirs' basis in property will not necessarily be the same as yours. If the property is transferred to them on your death, they will receive a "stepped up" basis. Their basis in the property will be the fair market value (FMV) of the property at the time of your death. If you give the property to them at any time before your death, they will inherit your basis in the property, which is likely lower than the FMV.
Let's say that you purchased a home in 1980 for $100,000. The house is now worth $300,000. If, for example, in 2015, you decided to transfer the house to your son. If you pass away in 2018, when the house is worth $300,000, your son's basis is the same as yours was: $100,000. If he sells the house for $300,000, he will be taxed on $200.000 in gains. If, on the other hand, you had retained ownership of the house and your son inherited the house upon your death, he would have received a stepped-up basis of $300,000, and there would have been no taxable gains.
In another possible scenario, you purchase an investment property for $700,000, and spend $50,000 on improvements. Your basis in the property is $750,000. You take annual tax deductions for depreciation, which lowers your basis by the amount of the depreciation claimed. After ten years, the building is worth $1.2 million. If you sell it, the portion of the purchase price above your now-lowered basis is taxed as ordinary income—the unfortunate flip side of the benefit of taking depreciation. But let's say you hang on to the building until your death, and let's say that at that time it is worth $1.5 million. Your heir inherits not only the building, but its stepped-up basis of $1.5 million dollars. You got the benefit of the depreciation, but at your death the downside of depreciation disappears for purposes of determining the building's tax basis.
The concept of basis applies to more than real estate. For example, placing stocks in a living trust can help avoid probate and taxation of your heirs' inheritance.
The concept of basis applies to more than real estate. Let's suppose you bought $100,000 in stock, which over time, appreciated to $300,000. Seeking to avoid probate, you gift the stock to your adult child on your deathbed. Your child gets $300,000 worth of stock, along with your $100,000 basis in the stock. If they sell the stock immediately, they will pay capital gains tax on $200,000, the difference between the basis and sale price. Assuming a tax rate of 25%, that amounts to $50,000 in tax. Had your child inherited the stock upon your death, they would have taken the stock at a stepped-up basis of the fair market value at the time of your death, or $300,000. If they sold it for that amount, they would have paid nothing in capital gains tax. In the first scenario, they avoid probate, but pay $50,000 in tax. The second scenario doesn't avoid probate, but results in a much lower tax burden. Furthermore, had you simply placed the stock in a revocable living trust, you could have helped your child avoid both probate and a tax bill.
Thinking about it this way, you may wonder why anyone would transfer property to a child ahead of their death and expose them to increased taxes. There are a lot of reasons. Some people seek to avoid the cost and expense of probate by transferring assets before death. Others fear they will need to go into a nursing home and have to "spend down" assets to qualify for Medicaid. Wishing to preserve their house for their family, they transfer it to the kids. (This type of "Medicaid planning" carries significant risks, and you should definitely consult with an elder law attorney before doing this.)
The problem with "DIY" estate planning designed to avoid a single issue, like having to go through probate, is that it almost always ensnares you in a different, unanticipated issue that might be even more costly. The best course of action is to consult with an estate planning attorney, whose experience allows him or her to see the big picture and meet your broader estate planning goals. We invite you to contact our law firm to schedule a consultation regarding your estate plan.