Income Tax Basis in Estate Planning

Income Tax planning is an integral part of Estate Planning. The first article in this series examined the concept of income tax basis, how it is acquired, and how it is adjusted. This article examines what happens to the income tax basis of an asset when it is gifted or bequeathed. There are different rules for the basis of an asset that is gifted than the one you own at death. That seems odd, but it’s true.

Let’s look at an example. John owned 1,000 shares of a stock he purchased for $50 per share. His basis in the stock was $50 per share or $50,000. The stock skyrocketed in value to $1,000 per share, so his 1,000 shares were worth $1 million. Since John had other assets, he decided to give the shares to his daughter, Betty, and then died the next day. Betty’s basis in the stock was the same as John’s at the time of the gift. She has what’s called a “carryover” basis. Let’s say Betty sells 100 shares for $1,100 per share, or $110,000. Betty will recognize a gain of $1,100 less her basis of $50, or $1,050 per share. Her total gain is $1,050 x 100 or $105,000. She’ll be taxed depending upon her other income.

However, the result would be quite different if John held onto the stock and then bequeathed it to Betty at his death. It doesn’t matter whether the transfer is made by John’s Will, Trust, or even due to a beneficiary designation. It only matters that John owned them when he died. Let’s say the stock was worth $1,000 per share when John died and the shares were bequeathed to Betty, rather than gifted to her. The basis of the shares of stock would have been “stepped-up” to their fair market value at John’s death. In other words, the basis would be $1,000 per share, or $1 million. When Betty sells 100 shares for $1,100 per share, or $110,000, she’ll have a gain of only $100 per share ($1,100 less $1,000) or $10,000, rather than $105,000. Her remaining shares also have a higher income tax basis.

This example illustrates the reason it’s typically best to give away assets that haven’t appreciated dramatically. As in most things, cash is king when gifting assets.

Gifting can be a powerful way to reduce the taxable estate. But due consideration must be given to the choice of assets to gift.