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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

tax cuts and reform

The Tax Cuts and Jobs Act of 2017 is now the “law of the land” starting in 2018

Tax laws have significantly changed with the passage of The Tax Cuts and Jobs Act of 2017. Our focus in this article is on the impact of this new law on individuals. Future newsletters will address the impact on Corporations, Pass-Through Entities, Trusts & Estates and Exempt Organizations.

Changes for Individuals – A Summary

  • Capital Gains rates remain at 20%
  • The Obamacare surtax of 3.8% on net investment income remains
  • The Medicare .9% surtax on wages and other ordinary income remains
  • The “Kiddie Tax” is new. It taxes minors like they are a trust. Rates start at 37% on unearned income over $12,500 annually
  • No more retroactive re-characterization of contributions to IRAs, as traditional or as Roth, or visa-versa
  • Personal exemptions were merged into the doubled Standard Deduction
  • The “Teacher Deduction” was doubled from $250 per year to $500 per year maximum deduction for classroom supplies
  • The Mortgage Interest deduction remains available on loans up to $1,000,000, but for homes acquired after 1/1/18, the mortgage amount is reduced to $750,000 and the deduction of HELOC interest has been eliminated
  • No more miscellaneous deductions or deductions for tax preparation fees
  • No more moving expense deduction except for Armed Forces members forced to move under military order

If you have any questions or would like to schedule a free consultation, please contact us at:

Port Orchard Office: (360) 876-6425

Seattle Office: (360) 509-4329

We hope these tax tips are helpful. Wishing all of our clients and friends a Prosperous New Year! From the Law Offices of Seward and Associates, Attorneys at Law

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

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.

2010 – the year without an estate tax

In 2010, and only 2010, the federal estate tax was repealed. What this meant was that the federal government was unable to tax the estate of an individual who passed away in 2010.

Many skeptics would find it hard to believe that the federal government sat idly by this past year and let millions of dollars in taxable revenue slip through their fingers. But this is, in fact, what happened. Famous names such as George Steinbrenner, Dennis Hopper, and Glen Bell (founder of Taco Bell) passed away this year, leaving behind large estates to be passed down to their families, with absolutely zero federal tax implications. From an asset protection standpoint, this lapse in government foresight is a blessing to us all.

But fear not skeptics, in 2011 the federal estate tax will be back in place. No one knows for sure what the tax rate will be, but sources have indicated that the tax could come back at upwards of 55% for all estates over $1 million dollars. This is a drastic change from the 2009 federal tax exemption, which was set at $3.5 million, with a tax rate of 45%.

While some might feel that an estate of $1 million dollars is a pie-in-the-sky dream, when you start adding up the value of a home, a 401K retirement account, and other savings, $1 million is not that far off. Individuals who live in areas with high property values could be especially susceptible. Those people who purchased homes 30 years ago, when property values in the Puget Sound area were much lower, could see significant gains in the value of their homes, greatly increasing the value of their estate and ultimately their estate tax burden.

Despite the 2010 lack of a federal estate tax, Washingtonians are still susceptible to a Washington estate tax on estates over $2 million dollars. In 2011, the possible hike in the federal estate tax, combined with the Washington estate tax, could result in a large tax burden for estates in Washington.
With proper estate planning, these estate taxes can be minimized or possibly avoided. Strategies that involve family gifting or the establishment of trusts can be very helpful in keeping the government from taking what is rightfully yours.

Attorney Jared Bellum is a contributing author to this blog.