Step Up in Basis

What is Basis and Why You Should Care

This dilemma may fall under the first world problems category. Nonetheless, I am sure even the most progressive among us can agree that a nearly 40% tax on proceeds from a brilliant investment you made decades ago (hello investing in a building in Bushwick or Amazon in the 1990s) is a bit excessive. I, for one, would like to at least talk about how that percentage could be minimized (or avoided altogether).

Basics of Cost Basis

Cost basis is the purchase price for the asset, be it building, art, or stock. When that asset is sold, capital gains tax will be due. If the asset is held less than a year, the seller is taxed at ordinary income rates. If the asset is held over one year, the more favorable long-term capital gains tax applies. When people talk capital gains, they usually mean the latter. These days, capital gains tax is dependent on income tax rates:

–       0% for individuals in the 10 – 15 % federal income tax brackets ($0 to $53,600).

–       15% capital gains rate for individuals in the 25% though 35% income tax bracket ($53,601 to $469,050). Also add Net investment income tax of 3.8% if modified gross income is greater than $200,000).

–       20% capital gains rate on individuals in the 39.6% income tax bracket (over $469,050).

That is just federal; there are also state capital gains tax, which NYS taxes as ordinary income. One cannot gift their capital gains away – the donee takes the asset at the donor’s original cost basis. But death, the ultimate equalizer, restores all. That is, if the asset is held until death – the beneficiaries’ cost basis is “stepped up” to the fair market value at time of death.

Exceptions to Capital Gains

One notable exception that can minimize or avoid capital gains tax pertains to real property. If the asset is the primary residential home that the seller has lived in for two of the past five years, the first $250,000 of profit on the sale of the home is excluded from capital gains tax ($500,000 for a couple). This exemption is allowable for an unlimited number of properties, but can be used only once every two years.

If the capital asset is commercial property, there is always the “like-kind” exchange under I.R.C. § 1031, which avoids capital gains by placing the gain into a new property. Technically, such an exchange delays capital gains.

Step Up in Basis to Fair Market Value at Death

The simplest way to avoid capital gains tax is to leave the appreciated asset to be distributed at death to get the step up in basis to fair market value at time of death. This obviously does not work for everyone – some people want or need to sell the asset.

There are specific “double step up” trusts for married couples that allow for a full step up in basis to fair market value at the date of death of the first spouse. Such trusts are a post for another day, but I am happy to schedule a consultation to discuss how these trusts operate.

Capital gains has become a hot topic with the Biden-Harris win because there are many proposed changes that will directly affect the basis step up at death and capital gains (boo!). Now is a good time to discuss the subject with an estate planning attorney. Book a free 1hr consultation today online.

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