Basis is one of those tax concepts that can really trip people up. This is true even though homeowners will likely have to think about capital gains while few people will ever have to worry about estate taxes with an exemption amount of $5.43 million in 2015. The good news is that there are a number of tactics to reduce or eliminate capital gains.
Basics of Basis
Capital gains taxes are triggered at the time an asset is sold – stocks, and real estate being the most common examples. In simple terms capital gains is the tax you owe on the difference between the price you paid for the asset (the basis) when you purchased it less the price you received when you sold it (the gain). As with all taxes there are a multitude of details, adjustments and exemptions that will impact the actual numbers.
Moving the Basis
One of the most common ways basis changes is when an asset is inherited. Transfers under a will or trust to a beneficiary change the basis to the current fair market value. That change is called a “step-up” in basis. This means the recipient can then sell the asset income-tax free.
The catch – you don’t get a step up in basis for gifts. That is why it is almost always better to make large gifts in your will or trust, and let the asset appreciate during your life. Your beneficiaries will then be able to take advantage of the new stepped-up basis.
Advanced Basis Tips
When the estate tax exemption amount was low, many people created irrevocable trusts to shield assets from estate taxes. The transfer to an irrevocable trust however meant that there wouldn’t be a step up in basis for those assets in the trust. What can you do with assets in an irrevocable trust to get the step-up back? One way, if the trust permits it, is to swap assets of equal value, but have a different basis. In other words, you’ll move your high basis asset into the irrevocable trust in place of the low basis asset, allowing it to step-up when your children inherit.
A word of caution: all of these steps should be taken with the advice of an experienced estate planner – if you make a mistake it could end up costing you or your beneficiaries extra taxes.
Understanding basis will help you see why a proper estate plan is a great value for your surviving spouse and your children.