There are quite a few taxes that come up in the field of estate planning: Estate Tax, Gift Tax, Inheritance Tax, Income Tax, Capital Gains Tax, and Generation-skipping Transfer Tax to name a few. Don’t understand these taxes and how they fit into your estate plan? Don’t worry, we do. We will discuss Estate Tax, Gift Tax, and Capital Gains Tax in this article.
To understand these three taxes, a quick introduction to an Internal Revenue Code (IRC) definition – Basis – is needed. IRC Section 1012 defines Basis as the cost of the property. For example, if you purchase a home for $100,000, or stock for $100,000, then your basis in those assets is $100,000. Basis becomes important when you decide to sell an appreciable asset. The difference between what you sell the asset for, and the basis is the gain that is potentially subject to taxation. This is what is known as Capital Gains Tax.
How does basis come into play in estate planning? Well, the basis your donee (the person you give your property to during life or after death via a will or trust) receives depends on WHEN and HOW they acquired the property.
When you choose to gift appreciable assets to someone during your lifetime, they keep the same basis you have. So, for example, you give that house you purchased that has a $100,000 basis to your child. Your child gets the same basis you have, $100,000. The home is now worth $500,000 and your child sells it. Well, the amount subject to capital gains tax is approximately $400,000 (the sale price and sales costs minus the basis).
On the other hand, if your child inherited the home from your passing, IRC Section 1013 allows a different calculation of basis for the property. IRC 1013 allows four different calculations of basis, the main one being the basis of property acquired from the passing of a decedent is the fair market value of that property on the date the decedent died. For example, suppose your child inherits your home when you pass away. Your basis was $100,000 (your cost). If the value on the date you passed is $500,000, then your child gets a new basis of $500,000. This is what is known as a step-up in basis. The nice thing about the step-up is that when your child sells the property, the gain subject to taxation is anything above their $500,000 basis and not your former $100,000 basis. Essentially, your child was able to make $400,000 gain on the property without being subject to capital gains tax.
Because of the huge impact basis plays on appreciable assets, you should carefully consider what assets you use to provide lifetime gifts to your beneficiaries versus having your beneficiaries inherit through a will or trust. If you would like to discuss your gifting or inheritance strategies, give Alfano Law a call to set up a time to speak with one of our estate planning attorneys.
You can contact Alfano Law by calling (603) 856-8411 or at this link.