When an investor initially acquires an asset, the term for the price paid is “cost basis.” Going forward, the cost basis may be adjusted for improvements to the asset, depreciation, reinvested dividends, etc.
The adjusted cost basis (or tax basis) determines the amount of taxable capital gain or loss associated with any subsequent sale of the asset. At that time, the cost basis is subtracted from the selling price to determine the taxable gain or loss.
It’s important to consider the tax basis of an asset for both financial and estate-planning purposes, as the rules are more complicated for gifting the asset during life or through inheritance. By knowing an asset’s tax basis and understanding the tax consequences associated with its disposition, you may be able to lower your taxes or those the beneficiary owes.
In this regard, “lifetime gifting” is a common wealth-transfer strategy. Here, the donor’s tax basis and holding period are transferred to the recipient.
Once recipients have assets in their name, they may face tax consequences upon subsequent sale of the asset. Investors may prefer to gift assets with less appreciation (higher basis) because, if/when the beneficiary sells the asset, the realized capital gain tax may be lower, depending on the seller’s marginal income tax bracket.
The adjusted cost basis (or tax basis) determines the amount of taxable capital gain or loss associated with the subsequent sale of the asset.
Alternatively, if the beneficiary is in a low tax bracket, it may be advantageous to gift highly appreciated assets, as the recipient may have a lower (or no) federal tax on capital gains when/if he or she decides to sell the gifted assets.
Unlike lifetime gifts, a beneficiary’s tax basis on an inherited gift is the fair market value (FMV) on the decedent’s date of death. Assets held until death generally receive a “step-up” in basis to FMV at death.
There is a caveat, however: If all of the assets are held by the husband, and the wife predeceases him, assets will not receive a step-up in basis until his death. Alternatively, if each spouse holds half of the assets, only half will receive a basis step-up at the first spouse’s death.
If it becomes apparent which spouse will die first, the couple may attempt to transfer all assets to the dying spouse in order to benefit from an earlier step-up in basis.
However, the IRS does not give a “step-up” to appreciated property gifted within one year of death. Should the decedent bequest property to the beneficiary who originally gifted that asset to the decedent, the IRS treats the gift as if it was never made. However, if the donor spouse transfers the assets to someone else (e.g. a friend or relative), this one-year rule does not apply.
Whether you prefer to gift during your life, pass your assets through bequests or sell them over time, knowing your assets’ tax basis is pivotal for determining the most tax-efficient strategy to use. The future of estate-tax rates, exemptions and the tax basis of assets is uncertain, making estate planning even more challenging.
Therefore, it’s important to consult with tax and legal advisors to ensure that your strategies remain consistent with your financial and personal objectives.
Note: An additional 3.8 percent surtax on unearned income applies if your modified adjusted income exceeds the threshold of: $200,000–single; $250,000–married, filing jointly; $125,000–married, filing separately.
This article was originally published in the August/September 2016 issue of Worth.