Understanding "Basis" Can Save Your Family $$$$$ in Taxes

As the dreaded April 18 tax deadline looms, income taxes are naturally on everyone’s mind.  If you own an asset that has appreciated greatly in value over the years, such as real estate or stock, you probably know that you will have to pay capital gains tax when you sell it.   The capital gains rate is 15% or 20%, depending on your taxable income.

Your capital gains tax will be calculated not on the entire sales price, but only on the amount the property has increased in value since you bought it.    Subject to some adjustments, the original purchase price is called your “basis” in the asset.  So if you bought stock in 2001 for $10,000 and sold it today for $60,000, you would pay capital gains tax on the $50,000 in appreciation.   If you give that stock to your child during your lifetime, he or she gets stuck with your $10,000 “carryover” basis in that asset.  That means, when they turn around and sell it, their capital gains tax will also be calculated using your original basis.

Knowing about basis is crucial when it comes to your income tax and estate planning.  People often decide to give away assets during their lifetime to qualify for Medicaid long-term care benefits or to avoid or eliminate paying estate taxes.   Unlike income taxes, which are paid each year, federal and state estate taxes are a one-time charge imposed at the time of your death, and are triggered if the total assets in your estate exceed a certain dollar threshold (in Massachusetts, that threshold is $1 million).  If you gradually gave away assets during your life, this could reduce your estate’s value below the estate tax threshold.

Before you give away assets, you need to ask your accountant about the capital gains taxation on transfers of highly appreciated assets from one generation to the next.   If you give away appreciated assets during your lifetime, you not only lose control and use of them if you ever need them in your retirement, but the person to whom you give them may pay a whopping tax when they eventually sell those assets.

Luckily, the tax code offers a better alternative.  If you wait to give that same asset away at your death, the person inheriting it does not inherit your basis.  Instead, they get a “step up” in basis, which typically is the fair market value of that asset on the date of your death.  So in the previous example, if that stock you bought in 2001 for $10,000 is worth $60,000 when you die, your beneficiary would get a new basis in the stock of $60,000, not $10,000.    If they turned around and sold it for $60,000, they would owe no capital gains tax.

Why this tax loophole?  Sometimes determining a decedent’s basis in an asset they held perhaps for decades is too difficult.   Also, since the government already imposes an estate tax on the transfer of some assets, collecting a capital gains tax could be double-dipping.  Ominously, there is now a proposal being floated in Washington to eliminate this stepped-up basis loophole.

So before you decide to give away appreciated assets during your lifetime, first consult your CPA, financial planner and estate planning attorney, so you fully understand the net impact of a carryover basis versus a stepped-up basis.  After all, future tax avoidance effectively increases the total value of the assets that you can leave to your family after you are gone.

Conveniently located in downtown North Attleborough, we serve clients from Massachusetts and Rhode Island, especially the communities of Attleboro, North Attleboro, Taunton, Norton, Foxboro,  Norton, Wrentham, Rehoboth, Plainville, Franklin, Mansfield, Seekonk, Providence, Woonsocket, Pawtucket, Cumberland, and Lincoln.

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