Only two things are certain in life — death and taxes. However, the proper planning can help your loved ones experience fewer tax headaches due to the Basis Step Up on Death.
When talking about the new basis at death rule, the first thing is to understand is basis. A basis is applied to any kind of property that can be sold. Things like houses, stocks, collectible items all have a basis. So what is a basis? The basis is the amount you can get back tax-free when sell an asset. So, if you buy an asset for $100, your basis in that asset is $100. When you later sell the asset for $250, you only have to pay capital gains taxes on the difference between your basis ($100) and the sales price ($250). So in this example, you would pay taxes on $150.
New Basis at Death
There are a variety of ways to calculate the basis that an asset has. Cost basis, as explained above, is the most common. When it comes to estate planning, another very common way is called the Date of Death Basis. Under a Date of Death Basis, the basis of the asset is the fair market value at the time the owner died.
For example, a buyer buys a rental property for $200,000 twenty years ago. In that time, the property has gone up in value, and is worth $800,000 on the date of the owner’s death. Under a Cost Basis calculation, if you were to sell the property, your profit would be $600,000 and that profit would be taxable. However, if the owner of the property dies, under a Date of Death Basis, the house is given a new basis on the day the owner died. The basis “steps up” from $200,000 to $800,000, the fair market value on the date of the owner’s death. What this means for the person who inherits the property is that if they sold the property before it gains more value, then the inheritor would have no taxable gain (and would not have to pay tax on the $600,000 gain!), because the basis was “stepped up.”
This Date of Death Basis can work as a “step down” too on assets that have decreased in value. It works much the same way as a step up. On the date of the owner’s death, the asset is given the basis of whatever the fair market value of that asset currently is, and any loss in value is erased for tax purposes.
For example, two years ago, a buyer buys a camper for $20,000. Over time, the camper depreciates in value, and on the date of the buyer’s death, the camper is only worth $5,000. The step down will erase the $15,000 loss in value. While the lost value cannot be recovered in a sale. It also means that you do not have to pay taxes based on the original value should you choose to sell the camper.
Basis in a Community Property State
One place the step up and step down is most important is when married couples are making their estate plans. Texas is one of a handful of states which has community property. Community property is property which is earned during the marriage. If an asset is acquired during the marriage, and using community funds, then that asset is community property. Property held be spouses before the start of the marriage is referred to as separate property.
Under federal tax law, if an asset is held as community property, then the entire asset gets a step up in basis on the death of either spouse. If the asset passes outright to the surviving spouse, the asset can also receive a second step up in basis on the death of the surviving spouse (this is often referred to as a double step up in basis). However, if an asset is held as separate property, it only gets a step up in basis on the death of the spouse who owns the property. Therefore, the classification of assets as community or separate property can have a big impact on income taxes, especially for assets that have appreciated significantly since they were bought.
We Can Help
All of these rules may seem confusing, but we can help you set up an estate plan to minimize your potential income tax liability. Taking advantage of the new basis at death rules can help maximize the assets that pass to your beneficiaries while reducing the amount that must go to Uncle Sam. Please give us a call to set up a meeting to discuss this or any other estate planning concerns.
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Nielsen Law PLLC provides family focused estate planning to individuals and families in Austin, Round Rock, Cedar Park, and the Central Texas area. For more information and to learn about our firm, please contact us.