Historically, the tax planning associated with estate planning focused primarily on saving estate taxes. Now, however, such tax planning is focused more on income taxes than estate taxes. This change is driven by the fact that the current estate tax exemption is $11.18 million per person ($22.36 million for married persons). To give you some perspective, 40 years ago the estate tax exemption was $134,000 per person (about $540,000 in today’s dollars). It has been estimated that less than 0.2% of estates will be subject to estate taxes under the current estate tax exemption amount. Accordingly, for most individuals and families, income tax planning trumps estate tax planning.
One aspect of income tax planning is basis planning. Basis is a tax concept which is used to determine the amount of taxable income a taxpayer must recognize when he sells an asset. For example, if a person sells an asset for $100 and his basis in the property is $60, then he has a taxable gain of $40. This article will provide a general overview of the basis rules regarding lifetime transfers (gifts) and testamentary transfers (inheritance) that should be considered when developing an estate plan for the first time or updating an existing estate plan.
When property is transferred during lifetime by gift, the general rule is that the recipient’s basis in the property received is equal to the donor’s basis in the property. For example, if X owns a parcel of land that he gifts to Y which has a fair market value (FMV) of $200,000 and a basis of $50,000 then Y’s basis in the property is $50,000. The effect of this rule is that any unrealized gain in the transferred property will be taxed to the recipient when the asset is sold. Accordingly, the basis of property should be taken into consideration when making gifts. This is illustrated by the following example:
Mother wants to make a gift to her son and daughter. Daughter receives stock with a FMV of $500,000 and a basis of $100,000 and son receives $400,000 of cash. Assuming that daughter sells the stock immediately after receiving it (and assuming the highest marginal federal and Arizona income tax rates applied), the daughter’s net after-tax proceeds would be approximately $386,640. While son might complain that his sister received more, son’s net after-tax amount was higher than his sister’s.
A wrinkle to the general rule is that if the donor’s basis in the gifted property is greater than the property’s FMV at the time of the gift and the recipient sells the property for less than the donor’s basis, then the property’s FMV will be the property’s basis for determining any loss. The effect of this rule is to prevent a donor from gifting property with a built-in loss to another person who could then sell the property and use the loss to offset other income. This is illustrated by the following example:
If a donor gifts property with a FMV of $50,000 and a basis of $100,000, then the recipient would recognize a $10,000 loss if he sold the property for $40,000, and the recipient would recognize a $10,000 gain if he sold the property for $110,000. The recipient recognizes no gain or loss if the property is sold for an amount in between $50,000 and $100,000.
The above example illustrates that the built-in loss of $50,000 at the time of the gift is lost and may not be used by either the donor or the recipient. Consequently, it is generally not a good idea from an income tax perspective to gift property with a built-in loss. Instead, the donor should sell the property so that he can use the loss to offset other income and then gift the proceeds from the sale.
The general rule for testamentary transfers is that the basis of property received from a decedent is the property’s FMV on the decedent’s date of death. For example, if a decedent owned a parcel of real estate with a FMV of $50,000, then its basis in the hands of the recipient will be $50,000 regardless of whether the property’s basis in the hands of the decedent was $1,000 or $100,000.
This rule effectively wipes out all unrealized gains and losses on property received from a decedent. Continuing with the gifting example from above, if the mother had held the stock with a FMV of $500,000 and a basis of $100,000 until her death so that the daughter received the stock as a testamentary transfer, then (assuming the property maintained its FMV) the property would have a $500,000 basis and the daughter could sell the stock without any income tax. By holding the stock until death, the mother was able to increase the total amount her daughter received.
Another exception to the general rule is that if appreciated property is gifted to a decedent within one year of the decedent’s death and the property is reacquired by the donor as a result of the decedent’s death, then an increase in the basis of the property is disallowed and the property retains its basis. This is illustrated by the following example:
A son owns land with a basis of $250,000 and FMV of $1 million. Son gifts the property to his father, and then his father engages in estate planning to assure that the property passes back to his son upon his death. If the father dies within one year of receiving the property, then the property’s basis in son’s hands will be $250,000.
If the father in the above example had lived longer than one year, then his son would have received the property with a new basis equal to $1 million. Under the right circumstances, using this technique can be a great way to eliminate income taxes on investment property.
When property is owned by two or more people and one of the joint tenants dies, the general rule is that only the decedent’s interest in the property receives a basis adjustment upon the decedent’s death. This includes property owned by spouses as joint tenants. For example, if husband and wife jointly own a rental property which they purchased for $100,000 (husband and wife each have a $50,000 basis in the property) and which is worth $500,000 upon husband’s death, then wife will receive husband’s interest in the property and wife’s new basis in the property will be $300,000 (wife’s initial $50,000 plus $250,000 (one-half of the FMV)). Accordingly, if wife wanted to sell the property for $500,000 after husband’s death, she would have about $200,000 of taxable gain.
There is, however, a special rule for property owned by spouses as community property. When spouses own property as community property and one of the spouses dies, the entire basis of the property receives an adjustment, not just the decedent’s interest. Continuing with the previous example, if husband and wife owned the property as community property rather than joint tenants, then wife’s basis in the property after husband’s death would be $500,000. Consequently, if wife sold the property for $500,000 after husband’s death, she would have $0 taxable gain. Thus, for spouses that live in community property states such as Arizona, it is almost always better to hold property as community property rather than as joint tenants.
Spouses that have moved from a non-community property state to a community property state may want to consider converting their property to community property in order to take advantage of this special basis adjustment rule for community property.
Income tax planning is an important part of estate planning, and the basis of property should be considered in connection with such planning, particularly in light of the current estate tax exemption. While income tax planning is an important part of estate planning and there are many income tax planning opportunities, there are also numerous non-tax issues that should also be considered. You should consult with your estate planning attorney and tax professional to discuss your estate plan before taking action.
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