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Step-Up in Basis

A Brief Introduction of Step-Up in Basis

By: Junfen Tang

Definition

Under Internal Revenue Code Section 1014(a), the basis of an inherited property from a decedent is generally (1) the fair market value of the property at the date of the decedent’s death, or (2) the fair market value of the property on the alternative valuation date.

Thus, when the above applicable fair market value of an inherited property is above its original purchase price that had been paid by the decedent, the heir who inherits certain property can use the fair market value as his or her cost basis and minimize the capital gains taxes owed if the property is sold later.

Why Step-Up in Basis

The underlying theory for step-up in basis is avoiding double taxation. Double taxation means that the taxpayer is taxed twice on the same income or assets.

In general, the taxpayer is subject to capital gain taxes for income generated from the sales of appreciated \ assets. If a taxpayer chooses not to dispose of his or her assets on or before his or her death, no capital gain taxes can be collected for the appreciation of these assets. However, the fair market value of these assets at the time of the death of the taxpayer shall be included into the deceased’s estate, thus, will be subject to estate tax, at least for those individuals with taxable estates.

Then, if the heir sells above inherited assets and is required to calculate capital gain based on the original costs in the hand of the deceased, the differences between the fair market value at the time of the taxpayer’s death and the original costs are likely to be taxed twice, which include the estate tax over the deceased’s related estate and the capital gain taxes upon the heir’s sales of these inherited assets.

Therefore, the U.S. tax code allows heirs to raise their cost basis to the inherited assets’ fair market value at the time of the decedent’s death, which means the heir obtains a step-up basis on the inherited assets.

How Step-Up in Basis Works

  1. Scope of application of the step-up in basis.
    The step-up in basis provision applies to real estate, other tangible property, and financial assets like stocks, bonds, and mutual funds as well.
  2. Determination of the step-up in basis.
    First, the step-up in basis is determined on the date of the owner’s death, or by using an alternative valuation date. The former calculation is relatively simple. For example, an inherited public security’s step-up in basis will be its closing price on the date of the decedent’s death or most recent trading date. While the step-up in basis is determined by using an alternative valuation date, the executor of the decedent’s estate must file an estate tax return known as form 706 and elect to use the alternative valuation on that return. Moreover, the step-up in basis must be the fair market value, which may be determined by the public market price of the same assets, the likely determination of the value of publicly traded stocks, or through a professional third-party assessment, for example determining the value of a piece of art.
  3. Step-up in basis for community property.
    Residents of the community property states, which include Washington state, can take advantage of the double step-up in basis rule. Community property means all assets accumulated during a couple’s marriage. A living spouse will be entitled the step-up in basis on the whole community property at the time of the other spouse’s death, not only for the fifty percent of the community property. Here is an example that may help your understanding of the double step-up in basis: Amy and Ben were married couple and residents of the State of Washington, a community property state. The couple purchased a house thirty years ago with a cost basis as $200,000. Ben passed away this year and their house’s fair market value increased to $800,000 at the date of Ben’s death. Ben was entitled to fifty percent of the value of the house and his estate will leave the house to his surviving spouse according to his will. If there are no applicable community property rules, then only Ben’s estate will have a step-up in basis, and Amy will have a new basis of $500,000 on this house. However, the community property rules apply, and Amy is allowed to a new basis of $800,000 on this house.
  4. No step-up in basis for lifetime gift.
    Although the step-up in basis provision applies to the inherited assets, for which titles are passed to heirs, beneficiaries cannot take advantage of the step-up in basis on properties that are gifted during the decedent’s lifetime.

Step-Up in Basis as a Tax Loophole

In fact, the step-up in basis provision has often been criticized as a tax loophole, which focuses mostly on the wealthy families that escape millions in taxes while their next generation enjoys the advantage of owning these assets. Like the above-mentioned underlying theory for the step-up in basis, the extensive amount of the estate tax exemption helps wealthy families to eliminate both estate taxes and capital gain taxes as well. Thus, the Biden administration and legislative leaders have developed a proposal to tax estates on the appreciation of the inherited property’s value. People are still waiting to see if the step-up in basis rules will be changed in the future as pressure on Congress to increase tax revenues continues.

Conclusion

Knowing the rules as outlined above, it is clear that the step-up in basis provisions should be included in your estate plan.  You are advised to consult with a professional tax advisor for assistance in this area of estate planning because of both the possibility of losing the advantages of a step-up in basis of appreciated inherited assets and the complexity of the application of the rules in this area.

Ms. Tang received her Master’s in Tax degree from the University of Washington School of Law

port orchard law

Port Orchard Law

Seward & Associates, Attorneys at Law, is pleased to announce our new association with Port Orchard Law.

Port Orchard Law is a firm dedicated to providing important Estate Planning services to the elder communities of Port Orchard and South Kitsap!

We know that planning for our cognitive decline and our “passing” are difficult topics to discuss.

We offer free consultations to help get the discussion started. The process includes recommendations that meet your goals of protecting what you have earned over your lifetime.

Completing the process brings “peace of mind”.

For an appointment, please contact us.

It’s a sign.

The new backlit signage that was recently installed at the Bethel Rd office is a sign (pun intended!) of our commitment to continue serving Port Orchard and nearby communities. We’re pretty excited about the new sign and how easily it is seen at night.

End of Life

Making End of Life changes to a will

End of Life

Making End Of Life changes to a will.

The following represents an actual call regarding someone making end-of-life decisions while in hospice. The question our caller asked illustrates a common problem for those individuals that fail to plan for their own cognitive decline.

Q:  I’ve been providing end-of-life care for my Elderly Friend. She expressed gratitude for the care and wanted to include me in her will but is currently in hospice, is not ambulatory, and is mentally incompetent. What can we do to meet her wishes?

A: If the Elderly Friend has executed a General Durable Power of Attorney (a “GDPOA”), then the Appointed Agent under the GDPOA can carry out her wishes, either through a contract to pay for the services, or to execute a codicil if the powers are specifically enumerated in the GDPOA. RCW 11.125.240 provides the Appointed Agent with broad powers to carry out her wishes.

Conclusion: The Elderly Friend did not have a GDPOA and due to her incompetency, she could not execute a GDPOA at this time. It was too late. Unfortunately, her wishes could not be carried out and court options were cost prohibitive. Proper estate planning could have avoided this result.

We hope these estate planning tips are helpful as we are dedicated to protect what you have earned!

If you have any questions or would like to schedule a free estate planning consultation, please contact us at 360.876.6425 or by email at richardsewardlaw@gmail.com

Estate Planning Seminar Announcement

Estate Planning Seminar

Wednesday, January 30, 2019

5:30 to 7:00 pm

Canterwood Country Club in Gig Harbor, WA

For those interested in Estate Planning and Wealth Management I am privileged to be able to extend this Invitation in association with RBC Wealth Management. The date is Wednesday January 30, 2019 from 5:30 to 7:00 pm at Canterwood Country Club. Come and obtain some meaningful information and have some fun! Complimentary gourmet meal immediately after the seminar. There are no costs of any kind and no obligation. Space is limited. You can RSVP to (253) 274-4363.

New tax cuts are “pending” and investment diversification as an asset protection strategy is more important than ever.

Have you considered diversifying your investments from the stock market to income-producing real estate?

We are seeing increased investment in income producing real estate such as apartments. The investment vehicle of choice for protection of business and personal assets and preferred tax treatment is the single member limited liability company (“LLC”) [1].

Single member LLCs – This entity is disregarded by the IRS for income tax purposes so all the tax benefits flow through to the member/investor on his or her 1040 personal tax return. The LLC files no tax return. Tax benefits include depreciation and interest deductions to offset the taxable rental income. Depreciation is a valuable non-cash deduction and it is based on the full purchase price excluding the land. The deduction is based on the premise that the improvements have a limited useful life so the investment is returned pro-rata over the useful life of the asset through depreciation deductions. This also lowers the tax payer’s basis in the property which increases the taxable gain on sale. That is where the magic of IRS Section 1031 comes into play.

IRS Section 1031 Like-Kind Exchanges – 1031 exchange tax deferral is available on sale if the net proceeds are reinvested in a qualifying “like kind” replacement property generally within 6 months of the sale. [2]The theory of tax deferral is that it is more of a theoretical gain if the investment continues in similar replacement property. This theory ignores the “step-up” in basis that is gained when the investor dies, and the “gain” avoids tax entirely. With the pending “tax cuts” this tax benefit may well be the first “offset” to go away.

Positive Leverage – With 75% positive leverage, a typical investment example follows:

A Typical Transaction:

A $1,000,000 purchase price, determined at a .06 capitalization rate, would look like this at the closing:

1) $250,000 cash down (this can be bifurcated into 5 LLC’s investing $50,000 each) and;

2) $750,000 in debt at a 4% interest rate, secured by the Property.

In this example, there is positive leverage on the $750,000 in debt of 2%. This is possible in the early years if interest rates stay at these historically low levels.

We are available to answer any questions you may have and we offer free consultations for anyone interested in discussing these investment diversification options. Call us at (360) 876-6425.

1. The 2003 Ashley Albright, Debtor, Case No. 01-11367 in the United States Bankruptcy Court for the District of Colorado made it more difficult for single-member LLCs where the member is in Chapter 7 to protect the business assets of the LLC from the trustee. Protection still exists from most creditors and personal assets continue to be protected from creditors of the LLC.

2. Property held for investment or for use in a trade or business qualify and the “like kind” requirements are very broad in terms of the kinds of real estate that qualifies. For example, an easement can be sold and reinvested in a fee interest.

Photo by Sweet Ice Cream Photography on Unsplash

Protecting your assets in a Trump administration – Planning Tips Revisited

This is Part 2 of a two-part article. Read Part 1 here…

Now that Donald Trump has been in office for several weeks, the expected changes that we discussed in our last newsletter — repeal of the Obamacare surtax, lower corporate income tax rates, lower individual tax rates, taxes on imports, and child care credits — seem to be on track given the rhetoric from the White House and the majority in the house and senate.

“Risky times are ahead.” – Gerald F. Seib

Read more

Tax Rates. How to protect your Assets in a Trump Administration.

tax ratesTax rates and asset protection in a Trump Administration.

Let’s talk tax rates. Now that Donald Trump is transitioning to the Presidency and we have a republican controlled House and Senate we can anticipate some “Reagan like” tax law changes. [1] When Reagan came into office, tax rates on unearned income were at 70% and the prime rate was at an all-time high of 21.5% and averaged 12.65% over the decade of the 80’s. [2] The Reagan administration lowered the tax rate on unearned income to individual rates on earned income and long-term capital gains were taxed at a reduced rate of 40%. Now with a Trump administration we might see tax rates as low as 15% on interest and dividends.

This article will discuss the “clues” that were revealed during the campaign [3] as to what changes we can expect and how to protect our assets going forward.

What changes, what tax rates can we expect?

  1. Repeal of the Obamacare surtax – The Patient Protection and Affordable Care Act of 2010 surcharge is equal to 3.8% of a taxpayers “net investment income” from dividends, rents and capital gains. [4]
  2. Lower corporate income tax rates. – Currently we have the highest corporate tax rate in the world, at 38.82 %, The next highest is France at 34.43% and the lowest is the United Kingdom at 20%. Expect Trump to push for a corporate tax as low as 15%. Businesses can also expect to benefit from an election that allows fully expensing plant and equipment costs by waiving the deduction to write off interest on business loans.
  3. Lower individual tax rates – Tax brackets will be reduced from 7 to 3 with tax rates at 12%, 25% or 33%, down from 39.6%.
  4. Taxes on imports – You can expect higher consumer prices through tariffs on imported goods which leads to inflation which in turn leads to higher interest rates.
  5. Child Care Credits – even for the wealthy. These credits are a central part of his tax reduction plan.

8 Year-End TAX Planning Tips. What are the key planning tips for asset protection?

  1. Consider deferring sales of assets such as income producing real estate as these will become more valuable if the surtax is repealed and your net proceeds after tax will be higher if the sale is deferred to 2017.
  2. May make sense to use C corporations to lower your overall tax rate. With corporate tax rates at 15% and your individual tax rates as high as 33%, the C Corporation can be used to shelter your income from income taxes while you grow equity in your C corporation.
  3. Increased job creation through government funded infrastructure type public improvements – see article by John Paul Turner below on The Power of Eminent Domain and the Government’s Right to Take Your Property.
  4. Protect investment accounts by diversifying into inflationary hedges and investments that do well as interest rates rise while avoiding health care and related industry investments that presents obvious risks due to the uncertainty in the industry.
  5. Refinance floating rate loans to fixed rates. Lock in these historic low interest rates!
  6. Defer income into 2017 and accelerate expenses into 2016. Income will be taxed at lower rates and expenses taken in 2016 will be more valuable.
  7. Defer gains on sales and even consider a 1031 exchange on sales of real estate assets. Even the sale of a conservation easement qualifies as a sale of a “real property interest” that would allow the net proceeds to be reinvested in income producing real estate assets with the rental income being spared of the surtax charge.
  8. Defer major capital equipment purchase to 2017 to take advantage of the write-offs. Pay cash if possible to avoid the loss of the business interest deduction.

General Recommendations – We can expect change and with change comes uncertainty, which makes investors nervous and more cautious, so it is a good time to re-evaluate your investment portfolio to make sure you have good diversification, including assets and liabilities that grow in value as interest rates increase, such as adjustable rate assets (adjustable rate bonds or annuities) and fixed rate liabilities (on your home loan, for example). Time to lock in these historically low interest rates!

1. I was 30 years old when Reagan took over the oval office. The prospect of change was exciting for young professionals at the time.
2.  The Prime Rate is the rate banks charge their best customers on loans. See http://www.fedprimerate.com/wall_street_journal_prime_rate_history.htm.
3. You can also visit the Donald J. Trump website at http://donaldtrumppolicies.com/
4. Or, alternatively, taxable income minus a threshold amount of $250,000 for married couples filing jointly, $125,000 for single filers, and $200,000 for all others.

Estate Tax and Estate Planning Updates

Estate Tax Update

Federal Estate Tax, Gift Tax and Generation-Skipping Tax Exemptions

The 2016 federal exemption against estate and gift taxes is up to $5,450,000 per person adjusted for inflation, up $20,000 from the 2015 exemption which was $5,430,000 per person. This is up from $5,120,000 in 2012. Estates in excess of this exemption amount are subject to a 40% federal estate tax. The federal generation-skipping transfer tax exemption was also increased to $5,450,000 per person.

State Estate Tax Exemption

The 2016 Washington State estate tax exemption is $2,078,000 per person up from $2,054,000 per person in 2015, adjusted for inflation. Washington estates in excess of this amount are subject to a 10% – 20% Washington State Estate Tax. Even though the Washington State estate tax exemption has been increased to $2,078,000, the filing threshold for the Washington State Estate and Transfer Tax Return remains at $2,000,000. Each estate over $2,000,000 is required to file a Washington State Estate and Transfer Tax Return. The exemption amount remained at $2,000,000 during 2012 and 2013, and was first increased to $2,012,000 in 2014.

Federal Gift Tax Annual Exclusion

The federal annual gift tax exclusion remains at $14,000 for 2016.

Estate Planning Update

Supreme Court States Inherited IRAs Are Not Exempt From Creditors’ Claims

If you have an Individual Retirement Account (IRA), funds held in your account are exempt from your creditors. In other words, if you are in a car accident and a judgment is awarded against you, your IRA cannot be seized as payment. However, it was unclear previously whether the beneficiaries who received your IRA following your death would receive the same creditor protection that you received. Recently, in Clark v. Rameker, the US Supreme Court clarified this. The Court reasoned that Inherited IRAs (e.g., IRAs left to a spouse, children, grandchildren, or friends upon a participant’s death) are not “retirement funds” and therefore do not receive creditor protection. The one exception to this rule is for IRAs left to a surviving spouse who then “rolls over” the IRA and treats it as his/her own account. In this case, the IRA will remain creditor protected.

IRA Trusts – Creditor Protection For Inherited IRAs

When one door closes, another opens. In the wake of Clark v. Rameker, IRA Trusts have become much more popular. While an Inherited IRA left to an individual is not protected from that individual’s creditors, an IRA left to an IRA Trust for the benefit of an individual can be protected from that individual’s creditors. An IRA Trust is a trust specifically designed to allow the IRA to remain tax-deferred – stretching the required minimum distributions from the IRA over the life expectancy of the beneficiary. The IRA Trust can allow these distributions to be accumulated in the trust and held for the beneficiary’s benefit, or the distributions can pass directly to the beneficiary. If the IRA Trust includes language that prohibits the IRA Trust beneficiary from voluntarily or involuntarily alienating his or her interest in the IRA Trust (commonly referred to as a “spendthrift” provision), the beneficiary’s creditors cannot reach the funds in the IRA or in the IRA Trust.

Key Asset Protection Strategy – Based on the above we are recommending that clients use an “IRA Trust” as their IRA beneficiary instead of directly to their children in what becomes an “Inherited IRA” on your death which is not protected from creditors. If you have questions or would like to discuss your personal situation, please contact us and we would be happy to discuss how you can protect your hard earned assets for the benefit of your family.

Estate Planning in the Digital Age

What happens to your online life when you die? Where will your online assets go?

These are questions that have never before crossed the minds of many estate planning attorneys, in fact, case law in this area is just beginning to develop. But as the digital age of social networking, cloud computing and paperless transactions has filtered into nearly every aspect of our lives, estate planning attorneys are beginning to request that their clients provide them with information about their online presence as part of the general estate planning questionnaire. This can be an extensive list, consisting of different user names and passwords from all the different websites that may have your information. Taking an inventory of your digital assets is a crucial step toward beginning to plan for that day when you are no longer physically able to tweet, pay bills online or update your status. Read more