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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 saving tips

Tax planning tips that can save you money.

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The article that follows is from our Holiday Newsletter. Subscribe to get up-to-the-minute information related to tax planning, and more.

Now that we are approaching our second year under the The Tax Cuts and Jobs Act of 2017 (the “Tax Act”) we have some money saving tips.

Tip # 1 – Take Advantage of the 20% Real Estate “Trade or Business” Deduction

There is a 20% tax deduction for all business owners and in particular those who invest in real estate. Real estate investors can conform their activity with their investment properties to become a “rental real estate trade or business” and take advantage of a tax deduction of up to 20% of “net profits.” The best part of this deduction is that it is exempt from the “phase-out provisions”. 1

To qualify, you must keep daily detailed records for each “rental real estate activity”. 2 There are two caveats: 1) You cannot use any rental as your own residence for even one day, and; 2) You cannot use a “triple net” lease.

Tip # 2 – Determine the Best Entity for your Trade or Business

In our last Newsletter, C Corporations (“C Corps”) were awarded the 1st Place Medal for benefiting the most from the new Tax Act. But what about the shareholders of C Corps? How did shareholders of C Corps fare?

After the shareholder of a C Corp pays income tax on their wages and other distributions they fall behind owners of “pass-through” entities because the income is subject to a second tax at the shareholder level. In contrast, “pass-through” entities pay no income taxes. The income is only taxed once at the shareholder level.

Conclusion: Use S Corps or LLCs as your entity of choice for your “trade or business”.


1.“Pass-through” entitles including S Corporations, partners, and sole proprietors qualify for a deduction of up to 20% of “Qualified Business Income” or the “operating profits” of a Trade or Business. IRC Section 199A contains all the complicated rules governing this deduction including income limits for the phasing out of the deduction for certain Specified Service Businesses including most professional service providers. This reduces the effective tax rate for “pass-through” entities from 39.6% to 29.6%. Real estate rental services can be performed by the taxpayer or their employees, agents or by their independent contractors to include the following services: advertising, tenant info verification, collecting rent, negotiating leases, managing, purchasing materials, and supervision of employees and independent contractors. Excluded are services such as financing or investment management activities or time commuting to and from the property.

2. Including time reports, logs, or similar documents, regarding the following (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which services were performed and (iv) who performed such services.  Such records are to be made available for inspection at the request of the Service. Starting in 2023, you will need to be averaging 20 hours a week in “rental real estate activity” to claim the deduction.


We hope these tax tips are helpful!

Photo by JESHOOTS.COM on Unsplash

The New Act

The "Big Winners" of The New Act
The “Big Winners” of The New Act

The “Big Winners.”

We are one month away from the end of the first year under The Tax Cuts and Jobs Act of 2017 (the “New Act”). In prior articles we discussed that the tax rate for C-Corporations was reduced from 35% to 21% clearly making all 1.7 million of the C-Corporations strong contenders for the “Big Winners” First Place Award 1. We also discussed the Impact on the 141.2 million Individual Taxpayers whose tax rate was reduced from 39.6% to 37% 2. Individuals also saw their state and local tax deduction limited to $10,000. Read more

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

The Tax Cuts and Jobs Act of 2017. Key year-end tax planning tips.

Tax law changes are coming so we have some key year-end tax planning tips and summaries of The Tax Cuts and Jobs Act of 2017.

Our focus in this article is this proposed law and the potential major changes to both the income tax laws and the estate and gift tax laws that we can likely expect. See our planning tips below.

Changes to Income Tax Laws – A Summary

  • Corporate rates – corporate tax rates are reduced to a flat 20% rate which is 2.5% below the average marginal rate for corporations worldwide. The intention is to make US corporations more competitive in the global marketplace. To partially pay for this, Congress increased the tax rate for C Corporations with taxable income up to $50,000 a year from 15% to 20%, but for most, rates will go down. If your income tax rates will be decreasing, then accelerate income to the current year to take advantage of the lower tax rates while you can.
  • The Section 179 expense – This deduction allows expensing the full cost of assets used in a trade or business. It will be increased from a current maximum deduction of $500,000 to a maximum deduction of $5,000,000 through 2022 with a 50% bonus for new property (except for depreciable real property). So, you can buy that jet or a fleet of bulldozers now.
  • Section 1031 “like kind” real estate exchanges – If you are contemplating a Section 1031 “like kind” exchange – Complete the transaction as soon as possible as there will be severe limits to the benefits of this section going forward.

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.

Dysfunction in Washington? So what!

So what if there is dysfunction in Washington – Good Times Continue. You can still complete family gifting with favorable exemptions and THERE IS STILL TIME for high income earners to cash in. Yes, tax rates are slightly higher, but you can offset that by taking advantage of the generous deductions that are still allowed for purchases completed by year end. See our tax tip below for more details!

So we all now know, Congress did not disappoint us last December. It did act. We did not go over the “fiscal cliff”. On January 2, 2013 Pres. Obama signed the American Taxpayer Relief Act of 2012, (“ATRA”) which had been approved by both houses of Congress one day earlier. ATRA is notable for averting the tax side of the so-called “fiscal cliff” by extending or making permanent favorable tax legislation passed in 2001, 2003, 2009 and 2010.
Indeed ATRA is perhaps the most significant tax legislation in nearly 12 years. Its primary focus was preserving income tax breaks only for those in the lower tax brackets. So, for married couples earning more than $450,000 annually, the marginal tax rate rose from 35% to 39.6% and the capital gains rates increased from 15% to 23.8% including the 3.8% Obama surtax, but there is one last loophole left. See below:

TAX TIP – BUY TANGIBLE PERSONAL PROPERTY FOR BUSINESS USE!
You only have several weeks to take advantage of the ATRA’s one year extension of the higher expensing limits and 50% bonus depreciation by buying depreciable tangible personal property for use in your trade or business. For example, on an $800,000 purchase, you would get a $500,000 IRS Section 179 deduction and another $180,000 in depreciation deductions. This very generous deduction goes away on December 31st.

So buy that bulldozer, copier, truck, van, or whatever personal property assets your business might need and do it before year end. You can even finance it. Preserve your cash flow and get a huge tax reduction in April.

2013 Could be a Rough Tax Year

Starting January 1, 2013, a number of tax breaks are set to expire, as well as a number of tax rate increases are set to come into effect.

They will hit families, small business, big businesses, investors, and just about every other category of Americans.  Personal income tax rates will increase, the capital gains tax rate will increase, business tax exemptions will be cut and educational tax exemptions will be decreased.  Be prepared…this may be a year we all have to tighten our belts a bit more.

Personal income tax rates will rise on January 1, 2013.
-The 10% bracket rises to a new and expanded 15%
-The 25% bracket rises to 28%
-The 28% bracket rises to 31%
-The 33% bracket rises to 36%
-The 35% bracket rises to 39.6%

Higher taxes on marriage and family coming on January 1, 2013. The “marriage penalty” (narrower tax brackets for married couples) will return from the first dollar of taxable income. The child tax credit will be cut in half from $1000 to $500 per child.  he standard deduction will no longer be doubled for married couples relative to the single level.

Middle Class Death Tax returns on January 1, 2013. The death tax is currently 35% with an exemption of $5 million ($10 million for married couples).  For those dying on or after January 1 2013, there is a 55 percent top death tax rate on estates over $1 million. A person leaving behind two homes and a retirement account could easily pass along a death tax bill to their loved ones.

Higher tax rates on savers and investors on January 1, 2013. The capital gains tax will rise from 15 percent this year to 23.8 percent in 2013.  The top dividends tax will rise from 15 percent this year to 43.4 percent in 2013.

Full business expensing will disappear. In 2011, businesses can expense half of their purchases of equipment. Starting on 2013 tax returns, all of it will have to be “depreciated” (slowly deducted over many years).

Tax Benefits for Education and Teaching Reduced. The deduction for tuition and fees will not be available. Tax credits for education will be limited.  Teachers will no longer be able to deduct classroom expenses. Employer-provided educational assistance is curtailed. The student loan interest deduction will be disallowed for hundreds of thousands of families.

Charitable Contributions from IRAs no longer allowed. Under current law, a retired person with an IRA can contribute up to $100,000 per year directly to a charity from their IRA. This contribution also counts toward an annual “required minimum distribution.” This ability will no longer be there.
As you can see, we are in line for a number of major tax changes that will impact our lives at nearly every level. Of course, all of this is subject to Congress doing nothing and making no changes. We will have to just wait and see and be prepared if these tax burdens to come into effect. We will need to make necessary changes to our budgets and our retirement savings strategies in order to be able to survive this tax increase and keep our fiscal goals within reach.

Attorney Jared Bellum is a contributing author to this blog.

2011 Changes in Tax Law

There were many political battles in Congress in 2010, but few were more heated than the debates revolving around the Bush tax cuts extension. The original Bush tax cuts, which were enacted in 2001 and 2003, were in serious jeopardy of sunsetting at the end of the year if Congress did not take action. This action would have caused virtually every American to experience a tax hike for 2011. Read more