David Lerner Associates: Analyzing Estate Planning and Income Tax Basis

David Lerner Associates: Analyzing Estate Planning and Income Tax Basis

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2015-04-02

 

April is the official National Financial Literacy Month. Improving one's understanding of the complexities of estate planning, gifts and income tax basis is one area almost everyone should tackle this month.

Income tax basis can be an important factor in deciding whether to make gifts during your lifetime or transfer property at your death. This decision affects the amount of taxable gain subject to income tax when the person sells the property.

What is an income tax basis?

Income tax basis is the base figure you use when identifying whether there has been capital gain or loss on the sale of property for income tax purposes. When a property is purchased your basis is typically equal to the purchase price. If you sell the property for more than your adjusted basis, you'll have a gain. Sell the property for less than your adjusted basis, and you'll have a loss.

What is the income tax basis for real estate you obtain by gift?

When you obtain a gift, you typically take the same basis in the property that the person who gave you the property (the donor) had. Example: Say your father gives you stock worth $1,000. He purchased the stock for $500. Say the gift incurs no gift tax. Your basis in the stock, for objective of determining gain on the sale of the stock, is $500. If you sold the stock for $1,000, you would have gain of $500 ($1,000 received minus $500 basis).

Now assume that the stock is worth only $200 at the time of the gift, and you sell it for $200. Your basis in the stock, for purpose of identifying gain on the sale of the stock, is still $500; but your basis for purpose of determining loss is $200. You do not pay tax on the sale of the stock. You do not recognize a loss either. Example: Assume your father gives you real estate worth $1,000,000. He bought the land for $200,000. Assume your father paid gift tax of $400,000 on the transfer. Your basis in the land, for purpose of determining gain (or loss) on the sale of the land, is $520,000 [$ 200,000 + $400,000 x (($1,000,000 - $200,000)/ $1,000,000)] If you sold the land for more than $520,000, you would have gain. If you sold the land for less than $520,000, you would have a loss.

Now assume your father gives you real estate worth $1,000,000, but he acquired the land for $1,200,000. Assume your father paid gift tax of $400,000 on the transfer. Your basis in the land, for purpose of determining gain (or loss) on the sale of the land, is $1,000,000. In this particular case, your father could have sold the land (and recognized the loss of $200,000-- his basis of $1,200,000 minus $1,000,000 received) and then transferred the sales proceeds to you as a gift.

What is the income tax basis for real estate you inherit?

When you acquire property, you generally receive an initial basis in property equal to the property's FMV. The FMV is established on the date of death or, sometimes, on an alternate valuation date six months after death.

Example: Say your mother leaves you stock worth $1,000 at her death. She purchased the stock for $500. Your basis in the stock is a stepped-up basis of $1,000. If you sold the stock for $1,000, you would have no gain ($1,000 received minus $1,000 basis).

Now assume that the stock is worth only $200 at the time of your mother's death. Your basis in the stock is a stepped-down basis of $200. If you sold the stock for more than $200, you would have gain.

Transfers within one year of death. If you transfer valued property to a person within one year of his or her death, and then you (or your spouse) receive the property back at that person's death, the basis in the property is not stepped up or down to FMV. Instead, the basis in the property is equal to that person's basis immediately before death. (And this basis is probably pretty close to the basis you originally had in the property before you transferred it.).

Income in respect of a decedent (IRD). There is no step up (or step down) in basis for IRD. IRD is certain income that was not properly includable in taxable income for the year of the decedent's death or a prior year. In other words, it is income that has not yet been taxed. Examples of IRD include installment payments and retirement accounts.

When you inherit IRD, you include the IRD in income as you receive payments, and take any associated deductions. An income tax deduction may be available for any estate tax paid that's attributable to the IRD.

In what way does generation-skipping transfer (GST) tax affect basis?

As discussed above, when you make a gift, the carried-over basis is increased-- but not above FMV-- by any gift tax paid that is attributable to appreciation in value of the gift. If the gift is also subject to GST tax, the carried-over basis is then increased-- but not above FMV-- by any GST tax paid that is attributable to appreciation in value of the gift.

Unique guidelines can apply when property in a trust passes at the death of an individual.

Should one make gift now or transfer at death?

As the following example shows, income tax basis can be important when deciding whether to make gifts now or transfer property at your death.

Example: You purchased land for $25,000. It is now worth $250,000. You give the property to your child (assume the gift incurs no gift tax), who then has a tax basis of $25,000. If your child sells the land for $250,000, your child would have taxable gain of $225,000 ($250,000 sales proceeds minus $25,000 basis).

If, instead, you kept the land and transferred it to your child at your death when the land is worth $250,000, your child would have a tax basis of $250,000. If your child sells the land for $250,000, your child would have no taxable gain ($250,000 sales proceeds minus $250,000 basis).

In addition to income tax basis, you might consider the following questions:

  • Will making gifts reduce your combined gift and estate taxes? For example, future appreciation on gifted property is removed from your gross estate for federal estate tax purposes. And gift tax paid on gifts made more than three years before your death is also removed from your gross estate.
  • Does the recipient need a gift now or can it wait? How long would a recipient have to wait until your death?
  • What are the marginal income tax rates of you and the recipient?
  • Do you have other property or cash that you could give?
  • Can you afford to make a gift now?

 

 

IMPORTANT DISCLOSURES

Material contained in this article is provided for information purposes only and is not intended to be used in connection with the evaluation of any investments offered by David Lerner Associates, Inc. This material does not constitute an offer or recommendation to buy or sell securities and should not be considered in connection with the purchase or sale of securities.

To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable-- we cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

Some of this material has been provided by Broadridge Investor Communications Solutions, Inc.

David Lerner Associates does not provide tax or legal advice. The information presented here is not specific to any individual's personal circumstances.

Member FINRA & SIPC 

 

 

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About

Founded in 1976, David Lerner Associates is a privately-held broker/dealer with headquarters in Syosset, New York and branch offices in Westport, CT; Boca Raton, FL; Teaneck and Princeton, NJ; and White Plains, NY. For more information contact David Lerner Associates Call 516-921-4200 Visit our website: http://www.davidlerner.com

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Contact

Jake Mendlinger
Account Manager
Zimmerman/Edelson
516.829.8374 X 232
jmendlinger@zimmed.com

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