Step right up…

… to understanding one of the most powerful tools we can use in estate planning, to save your loved ones lots of money. The great thing is, because this is an income tax savings, not an estate tax savings (which only helps multi-millionaires), this can work for almost everyone – not just the very wealthy. The key concept is something we call “basis step up.”  In this post, we’ll cover WHAT is “basis” and WHY it’s important. Next time, we’ll explain how and why your old trust could be unnecessarily costing your beneficiaries some, or all, of this ‘step-up’, and how to fix the problem.

What is “basis”? Well, if you buy something for $10, and sell it for $35, you have made a gain of $25, which you have to report on your income tax return, and which usually results in extra taxes, called capital gains taxes. The amount you put into the item you sold is called your “basis” or “tax basis.” This includes what you paid for it initially, and also what you paid to improve it (so, if you buy land for $10,000 and spend $50,000 to build a house on it, your basis in the property would be $60,000). Your gain – what you are taxed on – is arrived at by subtracting your basis from the amount you get for the property when you sell it.  So, if two people sell properties for the same price (say, $100), the one with the lower basis will have a higher gain, and therefore will usually pay more tax.

How does this work, though, with property you get by gift, or inheritance? Since you paid nothing for it, is your basis zero? Nope! If someone gives you a gift, then you get what we call a “carryover” basis – your basis is the same as theirs was. If I buy something for $10 and give it to you, then no matter what it was worth when I gave it to you, or how long you keep it, your basis will be $10. If you sell it for $100 – even if that was its value when I gave it to you – you will have a $90 gain. (Of course this gets more complicated if you pay just a little for something, so it’s really a “partial gift,” but that’s beyond the scope of this overview.)

BUT, it’s different (most of the time) when you inherit property – that is, you get it because someone died and left it to you. It doesn’t matter if you get it because they made a Will leaving it to you, because you were their natural heir, or because their  revocable living trust said that you get it when they die.*  Most of the time, if you get something when someone dies, your basis will be the market value on their date of death. So if they paid $10, but the property was worth $100 when they died, you will have a basis of $100! If you turn around the next day and sell it for $100, you will have zero gain (and thus, nothing to pay income tax on).

This basis step-up can be a great boon to your heirs or beneficiaries. Let’s say you paid $10,000 for a vacant building lot, and spent $40,000 to build a house on it (this was back in the ’60s, when money went a lot further). Your basis in the property is $50,000. But now, in 2014, thanks to inflation and the housing market boom, the property is worth $550,000, and rising. If you sell it, you will have a gain of $500,000. If it’s your home, you may be able to shelter some or all of that gain from tax; but if it’s not your primary home, or if you give it to someone else, such as your children, and THEY sell it, they will have a tax bill of over $100,000. If you leave the property to them when you die, though, they will probably have little or no taxable gain!

Now there are some exceptions to this. For example, you can’t just give someone something the day (or month) before they die, have them will it back to you, and get the higher basis. Also, the basis adjustment works both ways, so if the value goes down between purchase and death, you are stuck with the lower (date of death value) basis, which can mean more taxable gain.

Stay tuned for more about the basis ‘step-up’, and how to get the most out of it for your loved ones when you pass on.

*Some special kinds of trusts do not work this way, but here we are talking about the most common trusts, revocable trusts, which many people create to avoid probate and keep their affairs private when they die or become incapacitated.