TANNER PITTMAN, LLC
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Married couples can reap tax advantage for their estates by properly titling assets such as
real estate, securities, and other investments. For reasons that follow, most couples will
want to split their ownership of investment property rather than own it jointly.
Stepped-up basis.
Most clients know that there is a tax on capital gains. This is, broadly speaking, a tax on the
money you make from sale of an asset, such as land or stock. The IRS figures your
proceeds from sale by subtracting from the sale price the amount you put into the property.
The latter amount is called your “basis.” I.R.C. § 1012. If I bought property in 1960 for
$20,000, then the $20,000 is my basis. If I sell it in 2010 for $500,000, then I’m taxed on a
capital gain of $480,000. At current rates, I’d owe $72,000 in tax.
But what if I die before I can sell?
In that case, an interesting thing happens. My heirs inherit my property but not my basis.
The new basis they get is the fair market value of the property. I.R.C. § 1014(a)(1). It’s
known in the trade as a “stepped-up basis.” If, the day after I die in 2010, my heirs sell the
property, both their basis and the sale price will be $500,000. They therefore pay no tax. By
dying before the property is sold, I’ve saved my heirs $72,000.
real estate, securities, and other investments. For reasons that follow, most couples will
want to split their ownership of investment property rather than own it jointly.
Stepped-up basis.
Most clients know that there is a tax on capital gains. This is, broadly speaking, a tax on the
money you make from sale of an asset, such as land or stock. The IRS figures your
proceeds from sale by subtracting from the sale price the amount you put into the property.
The latter amount is called your “basis.” I.R.C. § 1012. If I bought property in 1960 for
$20,000, then the $20,000 is my basis. If I sell it in 2010 for $500,000, then I’m taxed on a
capital gain of $480,000. At current rates, I’d owe $72,000 in tax.
But what if I die before I can sell?
In that case, an interesting thing happens. My heirs inherit my property but not my basis.
The new basis they get is the fair market value of the property. I.R.C. § 1014(a)(1). It’s
known in the trade as a “stepped-up basis.” If, the day after I die in 2010, my heirs sell the
property, both their basis and the sale price will be $500,000. They therefore pay no tax. By
dying before the property is sold, I’ve saved my heirs $72,000.
| TANNER PITTMAN, LLC |
| TITLING PROPERTY FOR TAX ADVANTAGE |
That’s a morbid way to tax plan.
Now, granted, that’s a morbid way to tax plan. But your clients need not think about the proposition in so stark of terms. There are
really two lessons to take away from the stepped-up basis rule.
The first is that many people should “will” rather than “gift” highly appreciated property to their heirs.
The second rule is that, as between married couples, highly appreciated property should be titled in the name of the spouse who
will probably die first. If that’s hard to tell (i.e., if the spouses are of similar ages and health situations), title to property should be
split between them as opposed to held jointly. (n. 1) Read on to understand why.
The advantages of splitting title.
If there’s no strong likelihood one spouse or the other will die first, the best policy is to split title to property between the two. (n. 2)
There are many reasons why this is, (n. 3) but from a capital gains tax standpoint, the reason is that it’s better to have property with
two different bases than with a “blended basis.” Here’s how that works:
Scenario 1 – a blended basis. Say my wife and I own 1,000 shares of a stock with a basis of $0.01 and a value of $100. If we own
the stock jointly and I die first, the IRS allows my wife a stepped-up basis but only to reflect my one-half ownership. Julia therefore
gets a new basis in the stock of $50. This is the “blended basis.”
But there is still a capital-gains tax hit for every share of stock she sells. Say Julia only wants to unload 300 shares to raise money
for my funeral expenses. She’ll raise $30,000 (I specify a marble-plated, jewel-encrusted casket in my will) but have to pay $2,250
in capital gains tax.
Scenario 2 – a stepped-up basis in half the property. Imagine instead we had split the property during our lifetimes. I owned 500
shares and she owned 500. I die and she gets my shares, which will all have a stepped-up basis of $100. If all stock were sold
immediately, there would be no capital gains tax on my 500 but full taxation on hers. There’s no blended basis to worry about here
because I owned my stock outright. Her shares, in the meantime, retain their basis of $0.01.
Now assume again Julia wants to sell 300 shares for my lavish funeral. She may simply choose to sell 300 of my 500 and pay no
tax, for a savings of $2,250.
Comparing the two. It’s important to see here that the two scenarios produce the same tax result if the surviving spouse wants to
sell all of the property in question. Our 1,000 shares would be sold at a capital-gains tax hit of $7,500 regardless. But if the property
were split, and the survivor doesn’t want to sell all shares, a blended basis is a detriment to her. She wants to have no-tax sales
as long as she can get them and, if she isn’t in need of money, can leave the low-basis shares to her heirs so they too can then
receive a stepped up basis.
A final note on first-to-die planning when you know it’s coming.
If your clients are getting married and the husband is 30 years older than the bride-to-be, your advice should be to title as much
investment property as possible in the husband’s name. As he will very likely be the first to die, the wife will benefit in her later
years from his stepped-up basis.
But age isn’t the only way to predict a spouse will die first. To use me and my wife again, imagine I had incurable cancer. Julia
would want to convey as much investment property as she could to me so that, when I die, she and my children would get a
stepped-up basis and pay less tax on the property if they later need to sell it.
Either because they don’t want us thinking such morbid tax planning thoughts or because they want the Treasury Department to
get its pound of flesh, the Congress has in part closed this loophole. If you transfer property to a spouse and s/he dies within a
year, you do not get a stepped-up basis. (See I.R.C. § 1014(e)(1).) But it makes sense to make the transfer anyway if there’s any
chance your spouse will make it another 365 days.
This law may change. The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) repeals the one-year rule
beginning in 2010 and replaces it with a three-year look-back. I.R.C. § 1014(f)(sunset provision of old statute); I.R.C. § 1022 (new
statute).
But EGTRRA is itself set to “sunset” at the end of 2010. The conservative bet, however, is to assume that Congress will reenact the
three-year provision. (n. 4) Going forward, it is best to advise clients to assume a three-year look-back period and not count on
reaping the benefit of the sunset.
Notes
1. By “jointly,” here, I mean “joint with rights of survivorship.” This is the default “joint” rule for most bank accounts and mutual
funds. For real property, the default rule is that of no right of survivorship (known to lawyers as “tenancy in common”) unless the
deed specifies otherwise.
2. For reasons that are beyond this scope of this edition, this is not necessarily true of the family home.
3. Among the best reasons to split property between high-net-worth spouses is the credit shelter trust, which will be discussed in
a later edition.
4. One reason this assumption may be true is that EGTRRA had to sunset to avoid running afoul of the Byrd Act, which required all
legislation to be revenue-neutral within ten years. EGTRRA contained tax cuts, so it was not. But the three-year look-back is
effectively a tax increase, posing no Byrd Act problems. It could be easily reinstated even when other EGTRRA provisions aren’t.
Now, granted, that’s a morbid way to tax plan. But your clients need not think about the proposition in so stark of terms. There are
really two lessons to take away from the stepped-up basis rule.
The first is that many people should “will” rather than “gift” highly appreciated property to their heirs.
The second rule is that, as between married couples, highly appreciated property should be titled in the name of the spouse who
will probably die first. If that’s hard to tell (i.e., if the spouses are of similar ages and health situations), title to property should be
split between them as opposed to held jointly. (n. 1) Read on to understand why.
The advantages of splitting title.
If there’s no strong likelihood one spouse or the other will die first, the best policy is to split title to property between the two. (n. 2)
There are many reasons why this is, (n. 3) but from a capital gains tax standpoint, the reason is that it’s better to have property with
two different bases than with a “blended basis.” Here’s how that works:
Scenario 1 – a blended basis. Say my wife and I own 1,000 shares of a stock with a basis of $0.01 and a value of $100. If we own
the stock jointly and I die first, the IRS allows my wife a stepped-up basis but only to reflect my one-half ownership. Julia therefore
gets a new basis in the stock of $50. This is the “blended basis.”
But there is still a capital-gains tax hit for every share of stock she sells. Say Julia only wants to unload 300 shares to raise money
for my funeral expenses. She’ll raise $30,000 (I specify a marble-plated, jewel-encrusted casket in my will) but have to pay $2,250
in capital gains tax.
Scenario 2 – a stepped-up basis in half the property. Imagine instead we had split the property during our lifetimes. I owned 500
shares and she owned 500. I die and she gets my shares, which will all have a stepped-up basis of $100. If all stock were sold
immediately, there would be no capital gains tax on my 500 but full taxation on hers. There’s no blended basis to worry about here
because I owned my stock outright. Her shares, in the meantime, retain their basis of $0.01.
Now assume again Julia wants to sell 300 shares for my lavish funeral. She may simply choose to sell 300 of my 500 and pay no
tax, for a savings of $2,250.
Comparing the two. It’s important to see here that the two scenarios produce the same tax result if the surviving spouse wants to
sell all of the property in question. Our 1,000 shares would be sold at a capital-gains tax hit of $7,500 regardless. But if the property
were split, and the survivor doesn’t want to sell all shares, a blended basis is a detriment to her. She wants to have no-tax sales
as long as she can get them and, if she isn’t in need of money, can leave the low-basis shares to her heirs so they too can then
receive a stepped up basis.
A final note on first-to-die planning when you know it’s coming.
If your clients are getting married and the husband is 30 years older than the bride-to-be, your advice should be to title as much
investment property as possible in the husband’s name. As he will very likely be the first to die, the wife will benefit in her later
years from his stepped-up basis.
But age isn’t the only way to predict a spouse will die first. To use me and my wife again, imagine I had incurable cancer. Julia
would want to convey as much investment property as she could to me so that, when I die, she and my children would get a
stepped-up basis and pay less tax on the property if they later need to sell it.
Either because they don’t want us thinking such morbid tax planning thoughts or because they want the Treasury Department to
get its pound of flesh, the Congress has in part closed this loophole. If you transfer property to a spouse and s/he dies within a
year, you do not get a stepped-up basis. (See I.R.C. § 1014(e)(1).) But it makes sense to make the transfer anyway if there’s any
chance your spouse will make it another 365 days.
This law may change. The 2001 Economic Growth and Tax Relief Reconciliation Act (EGTRRA) repeals the one-year rule
beginning in 2010 and replaces it with a three-year look-back. I.R.C. § 1014(f)(sunset provision of old statute); I.R.C. § 1022 (new
statute).
But EGTRRA is itself set to “sunset” at the end of 2010. The conservative bet, however, is to assume that Congress will reenact the
three-year provision. (n. 4) Going forward, it is best to advise clients to assume a three-year look-back period and not count on
reaping the benefit of the sunset.
Notes
1. By “jointly,” here, I mean “joint with rights of survivorship.” This is the default “joint” rule for most bank accounts and mutual
funds. For real property, the default rule is that of no right of survivorship (known to lawyers as “tenancy in common”) unless the
deed specifies otherwise.
2. For reasons that are beyond this scope of this edition, this is not necessarily true of the family home.
3. Among the best reasons to split property between high-net-worth spouses is the credit shelter trust, which will be discussed in
a later edition.
4. One reason this assumption may be true is that EGTRRA had to sunset to avoid running afoul of the Byrd Act, which required all
legislation to be revenue-neutral within ten years. EGTRRA contained tax cuts, so it was not. But the three-year look-back is
effectively a tax increase, posing no Byrd Act problems. It could be easily reinstated even when other EGTRRA provisions aren’t.