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Diversified Capital Management

Estate Basis Adjustment

Basis is a critical component in income tax.

Generally, your basis in an asset is the purchase price of that asset, reduced by any depreciation or amortization if the property is used in a business or the property is rented.

The importance of basis:

Dan purchases 100 shares of X corporation in 2006 for $50 per share. Dan’s basis in the stock is $5,000. The fair market value of the stock today is $110, for a total of $11,000. If Dan sells the stock, the difference between the sales prices and the basis will be taxable income, in the amount of $6,000 in this example.

An exception to the general rule of basis applies to inherited assets. Basis in assets received through an estate generally have a basis in the hands of the recipient equal to the fair market value at the date of death, or the alternative valuation date if elected by the estate. This is opposed to assets received by gift, which generally will have the lower of a carryover basis or fair market value at the date of transfer.

So, let’s go back to Dan’s X corporation stock. If Dan sells the stock, he will have $6,000 of income. If Dan gifts the stock to his son Bob, and Bob sells the stock then Bob will have the $6,000 of taxable income. If Dan holds the stock until his passing, and it is inherited by Bob, then Bob can sell the stock and realize no income tax liability.

The basis replacement also works the other way, if Dan had an unrealized loss on stock, that loss would disappear as it goes through the estate, as the basis will be stepped down to fair market value.

The step-up or step-down occurs to all assets that would be included on the decedent’s estate tax return if one was required. Even if an estate tax return is not filed, the step-up or step-down will occur, adjusted to the fair market value that would have been shown on the return if one was required.

Understanding the impact of estate tax basis adjustment allows for individuals to make strategic tax savings decisions. As an example, an elderly person with a large unrealized gain on an asset should consider holding that asset until their demise to eliminate an income tax. Alternatively, that same person should review holdings and sell assets that could result in a taxable loss.

Of course, tax planning is only one aspect of the decision. Investment strategies and plans, cash flow needs and other personal issues will need to be considered as well as the income tax aspect.

Another issue often comes up, and that is how does a beneficiary know the basis in the asset they inherited. For the IRS, the issue is how do they know the basis? In 2015, the Internal Revenue Code was amended to required executors to furnish basis information to beneficiaries. But, even if an estate tax return is not required, the executor and beneficiary need to work together to determine the basis of the inherited assets.

There are a few exceptions to the basis increase rule, primarily related to income received in respect of the decedent. Property that would have been taxed to the decedent except for certain timing or tax deferral opportunities, will be taxable to the estate or beneficiary. The most common items this applies to are:

  • Wages earned but not received;
  • Deferred compensation arrangements;
  • Qualified retirement plan values;
  • Unpaid rents due to a decedent;
  • Gain from a sale essentially completed prior to death, but not received prior to a demise;
  • Installment sale balances due;
  • Annuity payments; and
  • Alimony.

Give us a call if you would like to discuss how these rules work, or if you have any other questions related to estates or estate planning.