This is an extremely valuable tool in the long term tax planning that saves middle class thousands of dollars in taxes every year. It also enables families to pass on their most valuable possessions at death without the need for beneficiaries to immediately sell it.
What is it? Under the federal tax code, if a tax payer holds an asset until his death, the owner’s cost basis for such asset rises to the full market value at the time of death. That means that the starting point for measuring a tax gain rises to the value of the asset at the time of death. This has huge tax saving implications for the people inheriting the asset.
How does it work? For example, your grandmother bought some stock 50 years ago for $50,000. Now that same stock is worth $1,000,000. If your grandmother holds the stock until her death and you inherit it, your cost basis in the stock becomes $1,000,000. If you sell the stock a week after her death, you will not have to pay any capital gains taxes.
On the other hand, if your grandmother gifts you the stock during her life time, then you will “inherit her basis,” and your cost basis of the stock remains $50,000. If you sell the stock for $1,000,000, you will need to pay capital gains taxes on $950,000. The same result is achieved if your grandmother sells the stock during her lifetime. She will have to pay capital gains taxes on $950,000.
Why the step up in basis was fair: some people think that by having a step up in basis, families are unfairly avoiding the taxes. But the estate tax catches an inheritance at the other hand. If the grandmother was holding the stock at her death, that stock was included in her estate. As a result, depending on the state in which you live in, both federal and state estate taxes may be due. New Jersey taxes estates that are greater than $675,000. New York State taxes estates that are greater than $2MM (set to rise to $3.1MM on April 1st). The federal government taxes estates that are greater than $5.43MM.
President’s Proposal: Under the President’s proposal, the step up in basis would be eliminated. Any time an asset would be inherited or gifted, it would be treated as a sale, and taxes on capital gains would be due.
Exemptions from the President’s proposal: There are some notable exemptions from the proposal, made in order to ease the burden on middle-class Americans.
- Capital gains of up to $100,000 per individual can be bequeathed free of tax for any type of asset.
- Capital gains of up to $250,000 per individual can be bequeathed free of tax for a personal residence.
- No tax would be due on inherited small business – until such business gets sold.
Implications for estate planning: If the proposals pass the Congress, most of the existing estate plans will need to be re-evaluated and likely modified. At this point, given a Republican-controlled Congress, it is unclear whether any of these proposals will actually become law.