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The Stepped Up Basis (October 2009)

In estate planning, it is important to understand “stepped up basis.”  When you buy property (for example, real estate or stocks) your “tax basis” in the property is the amount you pay for the property.  When you sell the property, you have profit or “gain” equal to the difference between the sale price and tax basis.  You have to pay “capital gains taxes” on your gain.

For example, suppose you bought a vacant lot many years ago for $10,000.  Now, that same land is worth $110,000.  If you sell that land for $110,000, your gain is $100,000 ($110,000 minus $10,000).  You have to pay capital gains taxes on that gain.  The federal capital gains tax rate for property held more than one year is generally 15%.  The State of Hawaii rate is 7.25%.  You would have to pay $22,250 in taxes.  (If you itemize deductions, you can take a deduction the following year on your federal income tax return for the state taxes paid.)

Instead of selling that land, suppose you give it to your son.  Your son’s tax basis in the land is $10,000.  When he sells that land for $110,000, he will have to pay the capital gains tax of $22,250.

Now, here is the tax planning opportunity.  Suppose after you bought that land for $10,000, you did not sell it and you did not give it to your son.  Instead, you hold on to the land until you die.  Your son inherits the land from you.  Then he sells it for $110,000.  He does not have to pay any capital gains taxes at all!  When you die owning that land, the tax basis in that land changes or “steps up” from $10,000 to $110,000 (the fair market value on the date of death.)  It is as if your son bought the property from you for $110,000.  When he sells it for $110,000, his gain is zero ($110,000 sale price minus $110,000 tax basis equals zero).  Therefore, his tax is zero.  Your son saves $22,250 in taxes by inheriting property from you instead of getting it from you while you are still alive.

This stepped up basis rule also applies to stocks, your home, and rental property.  (With rental property, the tax basis goes down every year as you depreciate the property.)  It does not apply to annuities or IRAs.  Here is another exception.  If you give property to someone, and that person dies within one year, and you or your spouse inherits that same property from that person, then you do not get a stepped up basis.

One of the best ways to get a stepped up basis for your home is to give it to your children, but keep a “life estate.”  You have given the home away, and protected it from nursing home costs, but you have the right to live there for the rest of your life.  When you die, because you kept the right to live there, the property gets a stepped up basis.  Your children could then sell it for the date of death value without paying any taxes.  (However, there is no stepped up basis if a person dies with a life estate in the year 2010.)  Our law firm has developed other techniques for getting a stepped up basis in other kinds of property such as rental property and stocks.

In 2009, a person can die with up to $3.5 million without paying any death taxes.  For many people, death taxes are no longer a problem.  We need to be paying more attention to capital gains taxes which our children or other loved ones may have to pay if they sell property we give to them.  Before you give away any real estate or stocks that have gone up or down in value, check with an estate planning specialist as to how the tax basis rules will affect your gift.

© OKURA & ASSOCIATES, 2009