Capital Gains

Capital Gains Tax

We discuss capital gains tax as it applies to estate planning and the tax consequences for a decedent’s heirs and beneficiaries.

The Carry-Over Basis

When individuals make gifts, both the asset and its cost basis transfer to the recipient. Therefore, when recipients sell gifts, they must pay capital gains tax on the difference between the sales price and the donor’s basis. This is called the carry-over basis.

For example: Diane buys a rental home $ 100,000. She builds an addition to the home at a cost of $ 50,000. Therefore, Diane’s cost basis in the home is $ 150,000 (the original cost plus the improvement). Diane gives the rental home to her daughter Sandy. Sandy’s basis in the property is the same as Diane’s: $ 150,000. If Sandy sells the property for $ 200,000, she will be liable for capital gains tax on the $ 50,000 profit.

The Basis Step-Up

If an asset is transferred as an inheritance rather than as a gift while the owner is alive, the capital gains tax on the asset is calculated differently. The basis is the property’s value as of the decedent’s date of death. This is called a basis step-up. Using the example of Diane and her daughter, Sandy, the following illustrates the basis step-up:

Assume that Diane does not give the rental property to Sandy as a gift. Instead, Diane leaves the property to Sandy through her will. As of the date of Diane’s death, the rental property is worth $ 200,000. Sandy’s basis is therefore $ 200,000. If she sells the property for $ 200,000, Sandy will not be liable for any capital gains tax.

Remember, the basis step-up applies only to after-death transfer of assets that are part of the decedent’s taxable estate. The basis step-up does not apply to gifts that individuals gave before death.

The Step-Up in Basis in 2010

Because estate tax is eliminated in 2010, not all of the appreciated assets in a decedent’s estate will receive this favorable step-up in basis. For the year 2010, step-up will be replaced by carry-over basis rules for assets exceeding $ 1.3 million. The basis step-up can be used to calculate the capital gains tax on the first $ 1.3 million of the assets in the decedent’s taxable estate when left to a nonspousal heir. Furthermore, transfers to a spouse will entitle the spouse to an additional stepped-up basis of $ 3 million. Assets exceeding $ 1.3 million carry the decedent’s basis or the date of death market value, whichever is smaller.

For example: Shirley has two assets when she dies in 2010: a family farm worth $ 1.3 million and a commercial office building also worth $ 1.3 million. Shirley’s basis in the farm is $ 300,000; her basis in the office building is $ 1 million. Because there is no federal estate tax in 2010, Shirley does not owe estate taxes. Also, the first $ 1.3 million of her estate receives a basis step-up. Her will leaves the farm to her son Mike. Shirley’s personal representative applies the basis step-up to the farm. As a result, Mike does not owe capital gains tax on the farm when he sells it. However, when Mike sells the office building for $ 1.3 million, he must use Shirley’s basis of $ 1 million, and he is subject to capital gains tax on the $300,000 gain.

Sale of Personal Residence During Life

Individuals who sell a primary residence can exclude up to $ 250,000 of the sale’s capital gains from capital gains tax; married couples can exclude up to $ 500,000, even if the residence is only titled in one spouse’s name. (Note that the couple must file taxes as married, joint.)

State Inheritance and Gift Taxes

Most states have inheritance or estate tax, and most states levy a tax on large gifts. In the past, these state taxes were often linked to the federal tax system. Many states had applicable exclusion amounts equal to the federal applicable exclusion amount. In addition, prior to EGTRRA, federal estate and gift taxes provided a credit to the estate equal to the amount of state inheritance or fit taxes that had been apid. This resulted in a dollar-for-dollar reduction in the federal tax for every dollar paid in state taxes.

EGTRRA reduced the federal credit for state gift and inheritance taxes in 2003 and 2004 and eliminated it in 2005. As a result, a number o states decoupled their inheritance and gift taxes from the federal estate tax. These states often have an applicable exclusion amount that is lower than the federal applicable exclusion amount. This change has important implications for seniors like Ross:

Ross dies in 2009 with an estate worth $ 1.2 million. He owes no federal estate tax because his estate is less than $ 3.5 million (his applicable exclusion). However, Ross resided in a state that has a $ 675,000 exclusion amount for inheritance taxes. As a result, Ross’ estate will be liable for state inheritance tax on $525,000.

You should find out if your state has decoupled its inheritance taxes from the federal estate tax and advise your clients accordingly.

The information above is reprinted from Working with Seniors: Health, Financial and Social Issues with permission from Society of Certified Senior Advisors® . Copyright © 2009. All rights reserved.