What is Tax Basis and Why Does It Matter?
There has been a lot in the news lately concerning the potential repeal of the step-up in income tax basis. While previous proposals have included such a repeal, the recent discussion draft from the House Ways and Means Committee does not repeal the basis step-up and does not include a capital gains levy on inherited property at death. So what is all this about tax basis and why does it matter? While determining tax basis can get very complicated, the original tax basis of an asset is going to be the cost of the asset. So, if you bought a parcel of raw land for $10,000, that is your tax basis. If you improve the land, that will increase your tax basis. If you then depreciate the improvements on your tax return, that will decrease your basis. Upon sale of the property, the gain is then taxed at the capital gains rates. So if, in our example, the tax basis in the land and improvements is now $100,000 and you subsequently sell it for $300,000, your taxable gain is the difference between your tax basis and the sales price, or $200,000. Pretty straight forward.
Where it really gets interesting is when people start giving assets away during life or at their death. If instead of selling the real estate, you give it to someone else during your lifetime, the general rule is that your income tax basis “carries over” to the recipient. This is known as carry-over basis. Therefore, in our example, their basis would also be $100,000 and if they then sell for $300,000 they will likewise have $200,000 of taxable gain. Under current law, if instead of giving it away while you are alive, you wait until your death, the potential gain (or loss) on the sale of the property is eliminated and the estate or heirs take the property with a new income tax basis equal to the fair market value of the property at the date of death. This is known as stepped-up basis. Therefore, if you pass the property described above to your heirs at your death and the fair market value is $300,000, the new tax basis is $300,000. If the property is then sold for $300,000 there is no taxable gain - a potentially significant tax savings!
The chart below shows what the federal tax savings alone might be:
| Carry Over Basis | Stepped-Up Basis | |
|---|---|---|
| Sale Price | $300,000.00 | $300,000.00 |
| Basis | ($100,000.00) | ($300,000.00) |
| Gain | $200,000.00 | $0.00 |
| Tax (23.8%) | $47,600.00 | $0.00 |
The Joint Committee on Taxation estimates that this step-up in basis saves taxpayers around $41 billion per year. When planning your estate, it is important to consider this important income tax consequence.
This post is for informational purposes only and not for the purpose of providing legal advice. You should contact an attorney to obtain advice with respect to any particular issue or problem. Nothing herein creates an attorney-client relationship between Hallock & Hallock and the reader.