Americans have been trained to fear the US Estate Tax system, sometimes called the death tax system.
However, now that a single person can transfer more than $5 million through the estate tax system without paying a tax, the time has come for us to change our way of thinking. We need to change our thinking because the estate tax system includes a hidden gift that is now extremely valuable.
The gift is this: Assets that pass through the estate tax system receive a new basis, which is the value of the asset on the date of death. Given the number of assets that have increased in value over the course of the past 40-50 years, the new basis at death is frequently an increased “stepped up” basis.
To begin at the beginning, the tax basis of an asset is generally the price that a taxpayer paid for the asset. The tax basis is important, because it is the measuring point for determining a taxpayer’s gain or loss on disposition of the asset. So, if a taxpayer paid $1.00 for a share of stock, then sells it for $10.00, the taxpayer’s gain is $9.00, and the taxpayer has to report that gain and pay a tax on it.
The lesson is: The higher an asset’s basis, the better.
The problem is that basis increases generally are not free. For example, if a person owns a rental property, he or she can increase basis by spending money on the property with the addition of a capital improvement. The basis adjustment is the direct result of spending money.
Historically, the basis adjustment that is available through the estate tax system – like other basis adjustments – came with a price tag. The property was subject to estate tax and it emerged from a painful taxation system with a new basis because it had generated a tax payable to the IRS.
Now, though the estate tax exemption is so high that people can use the estate tax system to acquire something that was inconceivable not so long ago: free basis.
The logic to free basis:
- The price of the basis adjustment at death has been the need to expose the asset to the estate tax system and the consequent need to pay an estate tax at high rates.
- Now, though, the estate tax exemption is so high that many people can expose their entire fortunes to the estate tax system without paying any tax, and many can do this without even filing an estate tax return.
- Since Congress did not change the basis adjustment rules when it changed the exemption amounts, the assets that go through the estate tax system painlessly (and perhaps without even filing a return) still receive a basis increase at no cost, which equals free basis.
The key underlying lesson to learn from the current situation is that – even if you cannot look at the US Estate Tax system as a friend – you can look at the system as a neighbor you need to learn to live with.
A few ideas to help you take advantage of free basis:
- Historically, parents have given assets that were likely to appreciate to children, so that the appreciation would not be exposed to the estate tax system at the parent’s death. However, when the gift was made, the parent’s basis would transfer to the child, and would not be stepped-up at the parent’s death. This made sense when the estate tax system imposed a price. Now that the system does not impose a price for most people, it makes sense for the parent to hold the asset until death so that it can be transferred to the child with a free basis increase.
- You probably have a natural aversion to taking money from your IRA, because you pay income tax on your withdrawals. However, if your aversion to taking money from your IRA were to cause you to sell an asset to pay tax at the capital gains rate, you might reconsider. The assets in the IRA will not get a basis increase when you die. The capital asset outside the IRA will get a basis increase. Your situation might be improved by taking money from the IRA and leaving the capital asset on hand so that it can be eligible for free basis.
- Think twice before making annual exclusion gifts with anything but cash.
- Don’t get involved with family limited partnerships and fractional interest discounting unless you are rich enough to really need them.
- Recognize that a traditional A/B Trust may result in the loss of a stepped-up basis at the death of the second spouse. While an A/B Trust can still make good sense for family reasons (especially dealing with a blended family), you should be sure that the trust has been modified to provide a method for obtaining an increased basis. The attorneys in our firm are adept at accomplishing this without disrupting family dynamics.