Nobody likes taxes.
And even though the federal estate tax is not a problem for most people anymore, there is another tax that could drain your estate and reduce what your loved ones receive after your death.
The good news?
By creating a solid estate plan, you dramatically reduce (if not eliminate) the need for your heirs to pay these taxes after your death.
That’s what this post is about: How to legally avoid having to pay taxes.
Related post: IRS Increases 2020 Estate Tax Exemption
[Disclaimer: I am not a tax professional and nothing in this article should be construed as tax advice. Consult a certified tax professional with any tax-related questions.]
Capital Gains Tax: Explained
America has a type of tax called the capital gains tax which says if you sell a capital asset (e.g., a house, shares of stock, etc.) for more than you paid to buy it, you may be taxed on the difference.
A few (oversimplified) technical terms:
cost basis = amount you pay to buy an asset
amount realized = amount for which you sell an asset
capital gain = amount realized - cost basis
For example: If I buy a capital asset for $10, my cost basis is $10. If I then sell the asset two years later for $15 (my amount realized), I would be taxed on the $5 increase in value, i.e., my capital gain.
This concept also applies if you gift someone a capital asset during your lifetime.
If Janet buys a capital asset for $20 and then gives it to me during her lifetime, I receive Janet’s $20 basis. This is often called a “carryover basis,” since Janet’s basis effectively “carries over” to me.
Therefore, if I sold the asset Janet gave me for $30, I would be taxed on the $10 gain.
How Stepped-Up Basis Can Save You Money
There is, however, a huge loophole to get around paying capital gains tax.
As stated above, if someone gives you a capital asset, you receive that person’s cost basis.
But if you inherit a capital asset, the decedent’s basis does not carry over. Instead, your new cost basis is the fair market value of the asset on the date of the decedent’s death.
This tax advantage is called stepped-up basis because, by inheriting an asset, the beneficiary’s cost basis “steps up” from the decedent’s old, lower basis.
As you might be able to guess, stepped-up basis can result in huge tax savings.
Sadly, however, families often (unwittingly) incur tens of thousands of dollars in avoidable taxes and miss out on this massive benefit by trying to do their own estate planning.
Consider this scenario,:
John is 85 and was recently diagnosed with a terminal illness. His most valuable asset is his house, which he bought 40 years ago for $35,000 — though it’s now worth over $135,000.
Because he does not want his son, Sam, to have to pay for probate, John deeds his house to Sam. John dies a week later.
Sam will not have to go through probate to get his father’s house, which seems like a good thing.
But it’s actually not.
Because John deeded Sam the house during his lifetime, Sam received John’s $35,000 cost basis in the property. This is called a “carryover basis,” since John’s basis was “carried over” to Sam. If Sam sold the house now, he would need to pay income taxes on the $100,000+ capital gain.
In other words, Sam could be looking at a $20,000+ tax bill.
Ouch.
And that could have been avoided by taking advantage of stepped-up basis.
You see, if John had let Sam inherit the house after his death instead of deeding it to Sam during his life, Sam’s new basis would be “stepped up” from $35,000 to $135,000.
If Sam then sold the house for $135,000, he would pay $0 in capital gains taxes on that sale.
By trying to save Sam the expense of probate, John ultimately cost him thousands in taxes.
Related post: 8 Reasons You Should Have a Living Trust
Don’t Lose Your Estate to Taxes
The good news is that you don’t need to end up like John in the example above: you don’t need to choose between probate or taxes. A living trust can give you the best of both worlds, avoiding probate while still allowing your loved ones to take advantage of stepped-up basis “loophole.”
To learn more about how you can help your family avoid unnecessary taxes by utilized “stepped-up basis,” contact the experienced Oklahoma City estate planning attorneys at Postic & Bates for a free, no-obligation consultation appointment.
David M. Postic is an attorney at Postic & Bates, P.C. His practice focuses on estate planning, probate, real estate, trust administration, business planning, and adoption.
You can email David through our Contact Us page or by calling our office at (405) 691-5080.
[As with all our blog posts and other publications and resources, the contents of this article do not constitute legal advice and are subject to our site-wide disclaimer.]
