Capital Gains -- What is basis and why do you care?

Basis is important in estate planning for a couple of different reasons.  When thinking about leaving property to your family, chances are, one of your goals is to "minimize taxes".  When people think about death and taxes, they often consider only inheritance or estate taxes, without giving much thought to capital gains taxes. 

In Massachusetts, we have a $1 million estate tax exemption.  This means that if you die with assets in excess of that amount, there may be an estate tax due.  I say "may" because there is no tax between spouses, so if you are married and your spouse survives you, there is generally no estate tax due.  In the same way, if you leave assets to charity, normally this reduces any estate taxes that are owed.  The Mass tax rate is a complex and unwieldy beast, but a person with an estate of $1.2 million would pay about 3.77% ($45,200) in total estate taxes.  However, all the assets have "stepped up" in basis, so if the kids sell them, they do not pay capital gains. So what?

The easiest way to think about this is with your primary residence.  If you and your spouse bought your house in 1970 for $20,000 and did an addition for $100,000, your adjusted basis would be $120,000.  Now, if your house is worth $1,200,000 today and your children inherit it, THEIR basis would be $1,200,000 (date of death value).  The value of the house "stepped up" to the date of death value.  If they sold it within several months of your date of death, there would be no capital gains.  Contrast this with making a lifetime gift to your children.  If you give something away during your life, the recipient takes your original basis.  So now they have the house with a basis of $120,000.  If they don't live there, but sell it after you pass away, their gain would be $1,080,000.  It would not be included in your estate, because you gave it away while you were alive, but when they sell it, they will wind up paying $270,000 in capital gains because the capital gains rate (Fed plus Mass) is 25%.  There would be no estate tax, but the capital gains tax rate is much higher than the Massachusetts estate tax rate.  Inheriting is often a better financial outcome for the next generation than receiving a gift of an appreciated asset.

Sometimes giving money away to reduce the size of your estate makes sense, and sometimes it does not.  It depends on how long you have held the assets and whether they have appreciated in value.  It depends on where you live (not all states have estate taxes and not all states have income taxes).  If you are considering gifting, you should get an understanding of the tax implications, perhaps by talking to your favorite estate planning attorney first!