Many estate planning decisions require balancing transfer tax considerations with future income tax consequences. An important factor in that analysis is an asset's basis, which can influence the tax burden associated with a future sale. Whether assets are transferred during life or at death may have a significant impact on basis and, ultimately, after-tax wealth. The following questions address several common basis planning considerations.
Basis generally represents your investment in an asset for tax purposes. Although an asset’s value may rise or fall over time, its basis may remain unchanged or be adjusted by certain transactions or events.
Basis helps determine the gain or loss recognized when the asset is sold. If an asset has appreciated, basis helps determine the amount of taxable gain. If an asset has declined in value, basis helps determine the amount of loss, although that loss may not always be deductible. As a result, basis is often a key consideration in estate planning decisions involving gifts or transfers at death.
Many assets included in your taxable estate are eligible for a basis adjustment at death. Generally, the basis of inherited property is adjusted to its fair market value on the date of death (or an alternate valuation date, if applicable). This is often referred to as a "step-up" in basis when an asset has appreciated in value, although basis can also be adjusted downward if an asset has declined in value.
This adjustment can significantly reduce or eliminate built-in capital gains. For example, if you purchased an asset for $100,000 and it is worth $1 million at your death, your heirs would have a $1 million basis, reducing and possibly eliminating the gain recognized upon a later sale.
Importantly, an asset does not always have to be owned outright to qualify for a basis adjustment. In many cases, assets held in trusts or other planning structures may also receive a basis adjustment if they are included in your taxable estate because you retained certain rights, powers or interests in the asset. However, not all assets receive a basis adjustment at death, making it important to understand how specific assets are treated.
When you gift an asset during your lifetime, the recipient generally receives your basis in that asset, often referred to as “carryover basis.” In other words, any built-in gain typically carries over with the asset. However, special rules apply when the asset's fair market value at the time of the gift is less than its basis. In that situation, different basis rules may apply depending on whether the recipient later sells the asset at a gain or a loss.
For example, if you purchased stock for $100,000 and later gifted it when it was worth $1 million, the recipient would generally inherit your $100,000 basis. If the recipient later sells the stock for $1 million, the gain is generally measured using the original $100,000 basis. Because of this, gifting appreciated assets can produce a very different income tax outcome than transferring those same assets at death.
Yes. Although basis is often discussed in the context of gifts and inheritances, it can change during your lifetime as well. For example, making capital improvements to real estate generally increases basis, while depreciation deductions claimed on rental or business property generally reduce basis.
Certain business interests, partnerships, LLCs and other investments may also experience basis adjustments due to various transactions during an owner's lifetime. Because basis can change over time, maintaining accurate records is important when calculating future gain or loss.
Transactions between family members or other related parties may also be subject to special rules, particularly when property is transferred for less than fair market value or at a loss. These rules can affect basis and the gain or loss recognized on a later sale.
Yes. In some cases, thoughtful planning can help maximize the benefit of a future basis adjustment. For example, taxpayers who have transferred assets to certain grantor trusts may be able to exchange or substitute low-basis assets held in the trust for higher-basis assets they own personally. If the low-basis assets are included in the taxpayer's taxable estate at death, they are eligible for a basis adjustment.
Basis can also affect charitable giving strategies. In some cases, donating appreciated property may provide more favorable tax benefits than selling the asset and donating the proceeds. However, the income tax deduction available for a charitable contribution is not always equal to the asset's fair market value. Depending on the type of asset, the recipient charity, and the donor's holding period, the deduction may be limited to the donor's basis.
Basis planning often requires balancing income tax and estate tax considerations. While lifetime gifts can be an effective way to transfer wealth, retaining certain appreciated assets until death may produce a better overall tax result because of the potential basis adjustment. One common mistake is focusing solely on estate tax savings without considering future income tax consequences. The right approach depends on your assets, family objectives and overall estate plan.
As tax laws, asset values, and family circumstances change over time, older estate plans may warrant periodic review. Many plans were designed when reducing estate taxes was the primary objective and may not fully reflect today's increased focus on basis and income tax planning. Understanding how basis works and how it can be affected by gifting and inheritance may help families preserve more after-tax wealth for future generations.
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