IRC 1014 & the Significance of Stepped Up Basis in Estate Planning

According to Internal Revenue Code Section 1014 the basis of property acquired from a decedent is the fair market value of the property at the date of the decedent’s death. This is often referred to as stepped up basis and it is profoundly significant for US taxpayers dealing with the myriad of issues surrounding estate planning or tax preferential transfer of assets.

For those of you not used to the term ‘basis’ it generally is defined as the cost or value of an investment, asset or something that is owned, given or inherited at the time it was acquired. It also refers to any investment in improvements made to the asset while you owned it.

A mentor, confidant, and all around great guy Frank Evans, shared his thoughts regarding estate planning and stepped up basis as one of my first guest authors. This post is for those of you anticipating or involved in generational transfers of assets and a worthy way to spend 5 minutes as my guess is that if you’ve made it this far in the post you probably are looking for a better understanding of how tax basis of an asset is determined, the step-up in basis at death for both separate and community property assets, or perhaps even the consequences and opportunities associated with low basis assets.

Frank helped me understand the rules governing when basis applies to IRAs and when it does not, as well as how to transform separate property into community property to get a full step-up of basis at the death of the first spouse.

So with that the following are Frank’s words…

Fortunately, there are numerous opportunities to avoid the huge and instant tax bill associated with selling low basis assets outright and for making the most of tax basis rules. Charitable Remainder Trusts, Family Limited Partnerships, Family Foundations, Installment Sales, or trust structures may be appropriate to dispose of highly appreciated assets, lowering the tax bill with reduced tax rates and charitable deductions.

Key Takeaways:

1. A step-up in basis is a wonderful thing. Assets get a step-up in basis at death; so for example when you inherit mom’s home and turn around to sell it be sure to understand what your true cost basis is in the home.

2. Tax deferred growth is a wonderful thing. Educating beneficiaries before they inherit can keep more money in their pockets in the long run (and their foot off a Porsche’s gas pedal).

3. Tax minimization is also a wonderful thing. Use tools such as the Charitable Remainder Trust (CRT) to dispose of low-basis, highly appreciated assets without setting off the IRS’s alarms and collection agents.

4. Counter intuitively, income tax returns are also a wonderful thing. Always review income tax returns annually. They provide a wealth of information that you may not know is valuable to basis management. We have found that if the return is not reviewed and basis questions are not asked, carry over basis and loss carry forwards are never mentioned. Thus, tax planning opportunities are lost. Don’t miss Wall Street corporate takeovers, rental property, and mutual fund red flags.

5. Team work is a beautiful thing as well. Make sure that basis step-up opportunities are always examined.

What You Need to Know:

First and foremost, stock or property needs to be held for longer than one year to avoid gains being taxed at ordinary rates for high-income payers. This is only an issue for those with marginal rates greater than 15%. In other words, if the marginal rate is equal to the gains rate — 15% — there is no practical impact.

Be sure to determine the capital gains tax impact if an asset is sold. Tax planning looks at future years in which income may be reduced (e.g., at the onset of retirement) allowing for a more opportune asset disposition of low-basis stock or property.

The capital gains rate is 20% for income subject to the
highest marginal rate of 39.6%; otherwise, it is 15%.

And then there’s the 3.8% Medicare surtax, effectively jumping capital gains from 15% to 18.8% (at $250k AGI married) or 23.8% ($450k AGI married).

Low-basis stock or property that has high appreciation is a wonderful thing from a wealth standpoint, but can produce very high capital gains taxes.

· If the stock or property is to be sold, then you must set aside the tax payment from the proceeds.

· If it is not set aside and the full proceeds are spent, when taxes are due, this could require pulling cash from future uses to the present (this is very inefficient and an example of poor execution).

Many people reading this likely own their own homes. Residential real estate has a $250,000 (single) and $500,000 (married) profit exemption from the capital gains tax with the main proviso that the home has been owned and used as a primary residence for at least 24 months.

And then there’s rental property to consider. Rental property may be entitled to a step-up in basis at the death of one of the spouses. Taxpayers often overlook this benefit.

Installment sales can be used to spread the gains on sales of businesses and rental properties such that gains are spread over a number of years to avoid running up the AGI ladder.

Community Property Trusts for married couples in separate property states are an effective way to get a double step-up in all assets owed by the couple no matter how titled. For larger estates, millions of dollars in capital gains taxes can be avoided with this relatively simple trust structure.

In addition, low-basis stock or real property are ideal assets for Charitable Remainder Trust (CRT) funding because the property passes to the trust at full value and without immediate capital gains tax implications.

· The CRT then can sell the property (after it’s owned by trust) and monetize the proceeds back to the grantor in the form of income.

· The income stream is four-tiered (return of principal, capital gains, tax-free income, and ordinary income) so the effective tax rate is lower than the ordinary income tax rate.

· The net is higher inside the trust than outside because the charitable exemption allows for the full proceeds to be available for the trust’s assets.

· The donor can take a charitable deduction for the donation to the trust, which can be especially valuable in high-income years (such as the last few years of earning employment compensation).

· The CRT income stream can be used to fund a significant life insurance policy (inside an Irrevocable Life Insurance Trust if your estate is federally taxable).

In addition, low-basis stock can also be gifted to Family Limited Partnerships (FLPs) and Family Foundations.

Using the FLP discount, the gift tax hit for the distribution is reduced. Of course, this mostly applies only to those families with wealth greater than the unified gift and estate tax credit (i.e., $11 million for a married couple).

Moreover, so long as the surviving spouse is an American citizen, the marital exemption allows unlimited low basis stock and property to be passed tax free upon the owner’s death to that spouse. (Lifetime transfers to an American citizen spouse are also unlimited.)

If these assets do pass through a marital transfer, it is vital that the advisor/estate planning attorney team execute a plan to address the surviving spouse’s estate/gift tax exposure.

And, keep in mind that often times, low-basis property or stock has emotional connections (e.g., a family business, a home or vacation home with sentimental value, or a treasured collection).

. Beyond the tax implications, it is important for parents to have not only the asset-disposition plan in place, but to have a family meeting to discuss the broader meanings of the stock and/or property.

· Parents may not want property they gifted to be sold, but the kids may be tempted to do so. If this is a concern, then a trust (with a non-family member as trustee) can be used to carry out parental intent.

· The tax implications for the beneficiaries can be handled by a number of trust structures to ease these worries.

· Property to be shared by siblings (e.g., a vacation home) needs to be discussed and the usage plan and rights be well documented to avoid conflicts before parents become incapacitated or die.

Assets get a step-up in basis at death, but most clients are not aware of that benefit; so, the mom who gives away the family home or other assets is likely creating a huge tax bill as well as subjecting her home to the creditors and bad acts of her children. In addition, she will be disinheriting any children who are not the recipients of the transfer as to that asset.

Lastly, remember that Porsche? An IRA’s basis is the after-tax balance formed by non-deductible IRA contributions as well as rollovers (after-tax amounts). Earnings on IRA contributions are tax-deferred.

Actions to Consider:

1. Include adult children and other beneficiaries in your counseling sessions, so they know the benefits of basis management and the disasters of mismanagement.

2. Participate in beneficiary preparation workshops.

3. Conduct a 1040 analysis to identify additional planning opportunities.

4. Create a customized action plan to better protect your beneficiaries from themselves, keep more assets under management, be the hero, and reduce the number of gut-wrenching basis management disasters you’re forced to witness.

5. Explore whether a Charitable Remainder Trust, Family Limited Partnership, Family Foundation, trust structure, or installment sale is appropriate to dispose of highly appreciated assets.

6. If you are the beneficiary or trustee of a non-grantor trust, analyze the trust to determine whether the trust can be decanted to grant the beneficiary a general power of appointment, bringing trust assets into his or her estate and using up any available federal estate tax exemption.