Income Tax Basis in Estate Planning

When considering different estate planning strategies and which direction to take, it’s important to consider the impact on basis. “Basis” is the benchmark used for income taxation.

What does income tax basis have to do with estate planning? Property included in your taxable estate at your death gets a “step-up” in basis to its value at your death. (Certain property like IRAs don’t get this step-up.)

However, when you gift an asset, the basis generally goes with the asset. Let’s say you purchase stock for $200,000 and it appreciates to $500,000. You are diagnosed with a terminal illness.

You want to put a simple do-it-yourself plan in place and you’ve heard probate can be cumbersome. So, you decide to give the stock to your son before you die. Doing so certainly avoids probate.

You succumb to the illness. Your son sells the stock after your death. Unfortunately, the stock did not receive a step-up in basis at your death because you had given it to your son before death. Your son received the stock with your $200,000 basis.

When your son sells the stock, he’ll pay capital gains tax on the gain of $300,000. Assuming a combined state and federal rate of 25%, he’ll pay $75,000 in tax upon the sale…a tax which could have been avoided with proper planning.

If, on the other hand, you had simply put the stock in a revocable trust, it would have avoided probate. Assets in a revocable trust are included in your taxable estate at death. Therefore, all the assets in the revocable trust receive a step-up in basis upon your death. If your son were the beneficiary of the trust upon your death, he would have received the stock with a basis equal to its fair market value at your death, or $500,000. Thus, it would have avoided probate without sacrificing the step-up in basis.

Giving the asset away prior to death was designed to avoid probate costs, which it did. However, it also resulted in a loss of income tax basis step-up because the property wasn’t included in the donor’s taxable estate at death. That simple gifting plan turned out to be pretty expensive after all.

This type of issue can arise in other estate planning strategies, as well. For example, in the past the amount you could pass without incurring estate taxes was much, much lower than today’s amount, which is now over $11 million. Thus, many people have plans in place designed to reduce the value of their assets for estate tax purposes. Strategies could include fractionalizing real estate, using entities with restrictions, etc. These strategies may still work to reduce the value in the estate. That’s great if estate taxes are still an issue for your estate with today’s increased exclusion. However, the value in the estate establishes the income tax basis of the asset, as well. So, if you don’t need to depress the value of the asset for estate tax considerations, you’ve unnecessarily reduced the income tax basis of the asset.

For example, let’s say you own only one asset, an asset worth $1.5 million. You have a strategy in place which diminishes its value to $1 million. When estates over $1 million were subject to estate tax, this was a great strategy because the $500,000 reduction in value would have saved estate taxes on that $500,000 excess. Estate taxes are now levied at 40% of the amount over the exclusion and used to be as high as 55%. So, the fact that the beneficiary might incur a capital gains tax up to 25% was a good trade-off. But, because your estate is under today’s exclusion of more than $11 million per person, you’ll pay no estate taxes even without the $500,000 reduction in value. Instead of the basis being $1.5 million at your death, it would only be stepped-up to $1 million because of the strategy. Thus, the strategy which was intended to save estate taxes could cost your loved ones $125,000 in increased income taxes after your death (assuming a 25% combined capital gains tax rate).

Estate planning is a complex weave of competing considerations. You want to save estate taxes, if they would be applicable. But, you also want to minimize future income taxes by being mindful of how different estate planning techniques may impact the future income tax basis.