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Adjusted basis vs. Carryover basis

There is an adjustment to the income tax basis of inherited assets received by an heir upon the death of the owner. However, if the asset is transferred by a lifetime gift, there is a carryover income tax basis. For example, let’s say Sally (the donor) buys an asset for $100,000 (which is her basis in the asset), and it appreciates during her lifetime to a value of $500,000. If she gifts the asset during her lifetime to her son, Jerry (the donee), his basis in the asset will be Sally’s basis when she received the asset, or $100,000. After receipt of the gift, if Jerry sells the asset at its current value of $500,000, he will be exposed to a capital gains tax on the $400,000 gain recognized on the asset’s sale. The highest long-term capital gains tax rate is currently 20 percent. Combined with potential state income tax implications, Jerry’s tax liability would be significant. Jerry’s tax burden could be even greater if he is exposed to the net investment income tax of 3.8 percent.

One thing to consider is that if Jerry has little to no other sources of income, then he would not have to recognize any capital gain on the sale of the appreciated asset because there is no capital gains tax for individuals whose taxable income is below a certain threshold. The question that clients, their attorneys, and other advisors often ponder is, should Sally make the gift to Jerry while she is living and possibly expose him to capital gains tax liability if he sells the appreciated asset, or should she gift the asset to Jerry when she passes away? It depends. This is where the planning and decision making comes in.

Adjusted (Stepped-up) basis

If Sally holds her appreciated asset until death, the income tax basis of her asset will be adjusted to equal the asset’s fair market value determined as of the date of her death. For example, if Sally holds the $500,000 asset until her death and then bequeaths the asset to Jerry, he will own the asset valued at $500,000—that is, with a $500,000 stepped-up income tax basis. Accordingly, if Jerry immediately sells the asset, there will be no capital gains tax implications. This strategy seems to make the most sense to limit an heir’s capital gains tax exposure upon the sale of an appreciated asset and is often recommended.

However, clients sometimes want to gift assets during their lifetime because it brings them joy to see their children or other loved ones receive gifts, or because they know the recipient needs the assets more now than they will years later when the client passes away. If an asset has not appreciated a significant amount during the donor’s lifetime, gifting during life may make sense because the capital gains tax implications for the donee would be minimal if the asset is sold. Also, as mentioned, gifting an appreciated asset during life to a donee who has very little income can make sense because that donee will not be required to pay capital gains tax if they sell the asset.

Often, a donor will gift an asset that has depreciated instead of appreciated. For example, let’s say Sally has an asset with a cost basis of $500,000 and a fair market value of $400,000 when she gifts the asset to her son, Jerry. If the asset increases in value after Sally makes the gift to more than what she paid for it, then Jerry will use Sally’s income tax basis to determine the capital gain to be recognized when he sells the asset. If the asset’s value decreases after Sally makes the gift, then Jerry will use the lower fair market value at the date of the sale to determine the loss to be recognized.

Proposed legislation. President Biden has proposed that the capital gains tax rate for those earning more than $1 million be increased to 39.6 percent, whether the gain is short- or long-term. This is a significant increase for top earners, whose long-term gains are currently taxed at the rate of 20 percent. As discussed, an additional 3.8 percent would be assessed for individuals subject to net investment income tax, bringing the rate to as high as 43.4 percent. This does not take into account state income taxes.

Of even more significance in Biden’s proposal is a $1 million per person (and effectively $2 million per married couple) exclusion from recognition of unrealized capital gains on property transferred by gift or held at death. Notably, the step up in basis would be eliminated for capital gains beyond the exclusion. In addition, it is possible that the capital gains tax would be assessed at the time of inheritance rather than at the eventual sale of the asset. This effectively eliminates a strategy that many clients rely on to pass appreciated assets to their heirs with no capital gains tax implications. At LeonardLaw, we will continue to watch changes in tax laws, particularly relating to capital gains tax exposure for gifting, so that we can help clients plan effectively.