Step-Up and Carry-Over What?!

I'm excited you're back to continue our geeking out discussion of Basis and its implications on your estate plan!  If you missed the first post on these topics, please head on over and get the foundation here!

In estate planning we look at two primary methods of gifting property.

1. Life-time Gifts
2. Gifts by operation of death

Each of these is treated differently by the IRS for Basis purposes.  Specifically let's consider any gift from the point of view of the recipient's Basis.  First, what investment does that recipient have in the property?  $0.00, right?  Which would make their presumed basis .... $0.00.  (Spoiler - the recipient's Basis isn't actually going to be zero, but we're not there yet!) 

The IRS who defines Basis for tax purposes hasn't taken quite THAT draconian of a viewpoint however, and at worst allows that recipient of a gift a "Carry-Over" Basis.  At best, the recipient receives a "Step-Up" Basis.  

1. Carry-Over Basis - The recipient takes over the basis that the donor had in the property.  So if Grandma and Grandpa give you the family farm that they purchased in 1940 for $100 an acre? .... your new basis is $100 an acre.
2. Step-Up Basis - The recipient takes as his basis the fair market value (fmv) of the property at the time of the gift.  So if you receive that same family farm and the current fmv is $15,000 an acre, your basis is now the $15,000 an acre.  

I want to now presume that a few years after having received a particular gift the recipient decides to sell the property.  At that point, the US (and likely state) government say .... CAPITAL GAIN ... give me, give me!  Capital Gain taxes are levied on the difference in value of property between the owners basis and the sales price.  

In a situation where Grandma and Grandpa purchased land 75 years ago for $100 an acre, they are at a significant risk of Capital Gain tax liability if they now sell the property for it's fmv of $15,000.  

The gain would be $15,000 - $100 = $14,900 per acre.  

Assuming a 100 acre farm, this means a total taxable gain of $1,490,000!!!!!

OUCH!!!

Well Grandma and Grandpa have no interest in loosing up to 20% of the cash they'd receive from the sale of this property to their friendly neighborhood federal government ... so they come up with a plan .... to GIVE that land to YOU and thus avoid the pesky capital gain.  After all, the appreciation in value occurred while they were the owners.  The government couldn't possibly expect the recipient of gifted property to pay taxes on it's value.

WRONG!

Here is where the recipient's basis becomes critical.  

If the recipient can get a step-up basis ... they're good to go!  Right?  Their basis will be equal to the fmv resulting in no gain and no tax.  

If the recipient is stuck with a carry-over basis ... trouble!  The recipient will be in the exact situation as the donors (Grandma and Grandpa) were.  

So, here is when each applies - 

When a gift is made during the donor's life - (an inter-vivos gift) - the recipient takes a carry-over basis in the property.

When a gift is made a a result of the donor's death - the recipient gets a step-up bases.  

Lesson to be learned for estate planning -

if you own property that has appreciated in value significantly, select those pieces of property to pass via your will or trust.

Use inter-vivos or lifetime gifting to remove assets which have not or do not appreciate in value from your estate (such as cash!).

Remember though, gift wisely and subject to the annual gift tax exclusion! 

Back to Basis

In my prior career-life I was a CPA. Today we are going to indulge a bit of my inner finance-geek in our discussion of Basis and how it can relate to your estate plan.  

I recently asked one of my non-accountant friends to define Basis for me and received the following reply:

Basis is like the foundation – Because the basis of an argument would be the foundation, right!?  

Well ... somewhat.  

In accounting, Basis measures you (the owner)’s investment in a piece of property.  

For example, if I purchase a piece of land (in dream world) for $100; my basis in that property is …

…..

…..

…..

$100.

Now let’s say I purchase a piece of land for $100 and then spend an additional $20 adding a fence around a portion.  Now my basis in the land would be $120.  

If, instead, I purchased land for $120 that already had a fence in place, but that fence was somewhat in disrepair, and I spend $10 to repair the fence … my basis is …. $120.  Repair costs do not get added to your basis.  

Only improvements add to basis.  

There are far more complicated rules for calculating basis in stock that has perhaps split or paid dividends and been reinvested.  Or the basis in a partnership interest where the owner may have contributed both cash and equipment and time to the business, and have removed income or dividends from that business. Your friendly neighborhood CPA can help you sort out these and other unique circumstances.  

For your estate planning purposes, however the general rule is important to know - 

Basis is the value that you have invested in a piece of property (real, investment, or otherwise)

Check back next post for an explanation of the two types of basis in non-purchased assets.