Proper Planning For The Basis Of Assets Can Mean Significant Tax Savings
The basis of assets is often an overlooked part of the planning process. This article will highlight a number of areas that can provide significant benefits to clients who address the issue.
Step-Up in Basis. Effective Jan. 1, 2004, the estate tax unified credit exemption amount jumped to $1.5 million per individual. Effectively, a married couple can pass $3 million tax free. Note that the gift tax unified credit exemption amount remains $1 million and does not change in the coming years.
As a result of these higher exemption amounts, it has been estimated that over 98% of Americans will not be subject to a federal estate tax liability, assuming they do basic planning.
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Planning: With the vast majority of estates being non-taxable, tax planning is going to shift from a focus on estate tax avoidance to a focus on income tax avoidance. For example, with the unified credit being $1.5 million (or $3 million for a married couple) in 2004 and a step-up in basis to a fair market value being provided at the time of the death of either spouse (IRC section 1014), we may see a reversal in asset valuation.
For years much of our fighting with the Internal Revenue Service has been to deny its argument that the estate was worth more than the client indicated, resulting in a higher estate tax. With the higher exemptions planners may actually want to drive up the value of the estate assets in order to get a higher step-up in basis and thereby reduce the future ordinary income (e.g., depreciation of depreciable assets) or capital gains (e.g., upon the sale of the asset).
Lifetime Basis Issues. But basis issues also exist during the life of the client. Many advisors are unaware of the unique basis issues which apply to gifts. In general, the donee of an asset takes over the tax basis of the donor. IRC section 1015(a) provides: If the property was acquired by gift…, the basis shall be the same as it would be in the hands of the donor … except that if such basis … is greater than the fair market value of the property at the time of the gift, then for the purpose of determining loss the basis shall be such fair market value.
The result of this rule is that the donors appreciation on the gifted asset normally will be taxed to the donee.
Planning: If a low basis asset is transferred to the donee, the value of the gift is effectively reduced by the income tax or capital gains tax the donee will ultimately pay upon the sale of the asset. For example, if a zero basis stock worth $10,000 is transferred to a child, the real value of the gift may only be $8,500 (i.e., $10,000 less a 15% federal capital gains tax). Instead, consider selling the asset and gifting cash of $10,000 to the child. Not only is a higher value transferred out of the estate, but the payment of the capital gains tax effectively reduces the donors estate.
Planning: One of the concerns with lifetime gifting using the unified credit has been the presence of low basis assets, with the donee having to use the donors basis rather than a date-of-death step-up to fair market value. With the unified credit increasing and the capital gains tax dropping, lifetime gifting using the unified credit may become an even more significant tax savings tool, even with low basis assets. For example, assume in 2006 a client funds a lifetime unified credit trust with zero basis assets worth $1 million that are growing at 12% per year. If the client is in a 45% estate tax bracket (i.e., the applicable rate in 2007), the 15% federal capital gains cost is recovered by the savings in estate taxes in about 3 years.
If the donor’s basis in the asset exceeds its fair market value, the rules get a little more complicated for the donee. If the donee subsequently sells the asset for a gain, the donee uses the donor’s basis in the property (Treasury Regulation section 1.1015-1(a)(1)). If the donee sells the asset for a loss, the fair market value of the donated assets is used as the basis. Thus, if the donee sells for a price between the fair market value and the donor’s basis, neither a loss nor a gain is incurred (Treasury Regulation section 1.1015-1(a)(2)). Unlike a gift, the basis of an asset transferred at death is the asset’s fair market value, even if the fair market value is lower than the asset’s date-of-death basis.
Planning: A terminally ill married client has a currently unmarketable asset which has reduced substantially in value (e.g., the basis is $500,000 and the value is $200,000). If the client dies, the assets basis will step-down to its fair market value, resulting in the family losing the tax benefit of the inherent loss in the asset. Instead, have the terminally ill client gift the asset to his spouse. If the spouse subsequently sells the asset for a value from $200,000 to $500,000, no taxable gain will be reported on the sale.