Foundational Tax Concepts for New Estate Planners

Feb 22, 2019 10:00:00 AM


In estate planning, tax issues are pervasive, and mitigating their effect on a client’s estate is a major component of an estate planner’s job. In order to effectively spot issues and provide more comprehensive advice, estate planners need at least a basic understanding of tax concepts. Having knowledge of tax issues may be the difference between representing a client entirely “in house” and losing the client altogether by referring them to the tax attorney or CPA down the street.

Let’s begin with three important foundational tax concepts—income tax basis, transfer basis, and stepped-up basis. Understanding these terms is key to determining any income tax consequences on the sale or transfer of the asset.  

Income tax basis. For most assets, basis equals cost. Basis, which is also referred to as cost basis, is the amount of the capital investment in the property, or how much the asset was originally purchased for. Knowing an asset’s cost basis is important in determining capital gains tax. Here’s how: If your client bought an asset for $80, then their basis is $80. When they sell the asset for $120, subtract the cost basis ($80) from the amount realized on the sale ($120) to arrive at the recognized gain on the sale ($40). This recognized gain is usually, and almost always, taxable. This simple example illustrates the general principle that, for income tax purposes, a high basis is desirable. The higher the basis, the lower the gain that is recognized on sale and the lower the taxes owed.

Carryover or transferred basis. Transferred or carryover basis refers to an asset that is gifted during one’s lifetime. When determining the basis of property that is acquired by a lifetime gift, an attorney simply needs to look at the donor’s original cost basis. For example, if a client bought Walmart stock for $50 and gives it to her daughter, then the daughter's basis in that stock would be the same as her mother's ($50). However, there are circumstances when an asset’s basis can be increased, usually by any gift tax paid that is equal to appreciation at the time of the gift.

Stepped-up basis. If an asset is passed to a beneficiary after the original owner has died, then the asset’s basis is adjusted to the value on the original owner’s death. This is commonly referred to as stepped-up basis because assets typically increase in value over time. Of course, the asset can also be stepped-down if the value on the date of death is less than what the original owner paid for the property. Determining an asset’s date of death or stepped-up basis is important because it usually helps to reduce a client’s taxable capital gain income on inherited assets that are being sold. It works like this: When someone dies, an asset receives an adjustment to its basis, so that it reflects the fair market value on the date of death. For example, Ed paid $200,000 for a condo and then left that condo in his will to Jane. When Jane inherited the condo, its market value was $450,000. So, her new basis would be stepped-up to $450,000. This step up in basis is favorable because if Jane immediately sells the condo for $450,000, she will recognize no gain on the sale. If Ed had instead given the property to Jane during his lifetime, then Jane would not have a basis step up and would instead have carryover or transferred basis. Jane may have recognized a gain of $250,000 (e.g., $450,000 sales proceeds less $200,000 basis). Recall the general rule: High basis is desirable!

Although it doesn’t happen as often, it is possible for an asset’s fair market value to end up being lower than its cost basis. In this circumstance, the adjusted basis would be stepped-down rather than up. Despite this possibility, most estate planners and tax planners still use the term stepped-up basis because assets generally do appreciate over time.

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Advising clients using the concepts of basis

When it comes to advising clients on the best way to transfer an asset, basis can play a strategic role. Whether or not your client should hold onto an asset or gift it during their lifetime involves many different factors, such as the size of their estate, a beneficiary’s ability to pay higher capital gains tax, the client’s goals, etc. Generally, holding property until death is more advantageous from an income tax perspective. That is because the step-up in basis erases any unrealized appreciation in the property that accrued prior to death.

For example, let's say that Nancy buys some land for $20,000. Years later, she decides to gift it to her daughter, Liz. Because it is a lifetime gift, Liz will get a transferred basis. When she sells it for $100,000, she will have to pay capital gains on the $80,000 gain.

In another scenario, Nancy decides she’d rather leave the land to Liz in her will. When Liz inherits the land, she gets a stepped-up basis to reflect the land’s current fair market value ($80,000). When Liz decides to sell the land a few years later for $100,000, she will only have to pay capital gains tax on the $20,000 gain.

These examples show that transferred basis usually triggers a much larger tax burden than a stepped-up basis. In a lifetime gift scenario, when the recipient eventually sells the property, they will pay tax on any gain that accrued in the property before they acquired it. In this case, if Nancy were worried about Liz’s ability to pay tax on capital gains, then the attorney may advise Nancy to leave her land to Liz in a will or trust.

Having some foundational knowledge of tax concepts is key to creating a comprehensive estate plan that is beneficial for both the client and their heirs. If you’re a new or transitioning estate planner (or just want to brush up on your tax knowledge), learn how you can become a WealthCounsel member and have access to our vast library of resources.

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